Benefits and Risks of Using Fixed Income ETFs
Benefits to Using Fixed Income ETFs
Fixed income ETFs have revolutionized the fixed income landscape and help bring liquidity, transparency and ETF diversification to investors. By purchasing a fixed income ETF, an investor can obtain exposure to a certain segment of the fixed income market in one trade, reducing the need to research, price, purchase, and manage a large number of individual bonds.
Fixed income ETFs are designed to track institutional quality indices much like bond mutual funds do, but fixed income ETFs can be bought and sold on a public exchange, like a stock. Fixed income ETFs tend to offer low management fees and increased liquidity.
Benefits of fixed income ETFs include:
- Diversified exposure to various sectors of the fixed income markets
- Low management fees
- Transparency of pricing and holdings
- Intraday tradability helps provide flexibility and liquidity
- Tax efficiency
- Modular product set allows investors to construct bond portfolios with specific credit quality and/or duration profiles
Risks Associated with Fixed Income ETFs
As with any asset class, investing in fixed income entails certain risks. The following is a quick summary of those risks:
Interest Rate Risk: As interest rates rise and fall the present value of the bond and its future cash flows will change, which, in turn, affects its market price. (See Section 2)
Credit or Default Risk: The risk that the issuer will not be able to make interest and principal payments to bondholders. Typically, bonds with lower credit ratings will offer higher interest rates in order to compensate investors for the additional risk.
Prepayment Risk: The risk that a bond with a callable feature is called by the issuer. From an investor's standpoint, this is disadvantageous because of the uncertainty of cash flows and the potential exposure to reinvestment risk.
Reinvestment Risk: The risk that cash received from a callable or maturing bond is reinvested at a lower interest rate.
Market risk: The risk that an overall market decline may adversely affect the value of individual issues even though those investments still have strong fundamentals.
Liquidity risk: The risk that an investor may be forced to sell a security at a loss due to difficulty of finding a buyer (a greater risk for thinly traded individual bonds).
Inflation risk: Inflation is the rate at which purchasing power is decreased over time; that is how much you can buy today with $1 vs. how much you will be able to buy 10 years from now. The longer the investor has to wait to get his or her initial principal back, the greater the chance that higher than expected inflation will reduce the value of the principal and interest payments.