The bond ETF market has grown massively in recent years. Given the newfound popularity of bond ETFs, you might be wondering how you can integrate them into your portfolio. In this article, we explore the ins and outs of bond ETFs. We also look at the reasons they're popular, and what to consider before investing in them.

What are bonds, and how do they work?

Think of bonds as a type of loan. When you’re buying one, you’re lending money to a particular party – like a corporation or government body – so they can finance various activities and projects.

That party then promises to pay you back over time. They do this through a mix of regular interest payments and the reimbursement of your initial investment (known as the principal) once the bond matures. (Bond maturity simply refers to the point when the bond issuer has to pay back your original investment. It can be short, medium or long-term.)

There are numerous potential upsides to investing in bonds, including their relatively low risk, the high likelihood of getting your money back, and the passive income received via interest payments.

You can learn more about bonds in our guide to "What are bonds, and should I investin them?".

How do bond ETFs work?

Bond ETFs work in much the same way as other ETFs. They can be bought and sold on the ASX, they’re fairly cost-effective, and they let you invest in multiple assets in a single trade. They’re also passively managed investments, meaning they generally track a particular index instead of trying to beat it.

Bond ETFs, however, only invest in bonds. They usually contain a selection of bonds across different issuers, sectors, markets and/or maturities.

Plus, like individual bonds, bond ETFs can offer periodic payments. They take the interest earned on the bonds within their portfolio and distribute dividends among shareholders on a regular basis.

Are there different types of bond ETFs?

There sure are! Just like there are multiple types of bonds, there are several varieties of bond ETFs. Broadly speaking, these include:

• Corporate bond ETFs. These ETFs (perhaps unsurprisingly) concentrate on corporate bonds. Many invest in corporations deemed ‘investment-grade’ – those that have a lower risk of defaulting on their debt. High-yield bond ETFs invest in below-investment-grade corporations that are higher-risk but promise larger interest payments
• Government bond ETFs. Government bond ETFs comprise bonds issued by government agencies, including state and federal governments, treasury corporations, and international bodies. There are bond ETFs that only focus on Australian government bonds. Others include international bonds. Then, some invest in specific government bodies – like treasuries
• Composite bond ETFs. Also known as aggregate bond ETFs, these contain a mix of bonds across corporate, government, and other issuers
• International bond ETFs. These bond ETFs allow you to invest in bonds issued outside Australia. On Pearler, for example, there’s a diverse range of US bond ETFs that cover both corporate and government issuers

What are the advantages of investing in bond ETFs?

There are lots of reasons to consider investing in bond ETFs. Below, we look at their advantages compared to bond funds (mutual funds that invest in bonds) and traditional bonds.

• Investing in bonds made simple. Only a small selection of bonds are available on the ASX, and these are only Australian Government Bonds (AGBs). Corporate bonds can usually only be traded ‘over-the-counter’. On the other hand, numerous types of bond ETFs are available to trade via the ASX. These can be bought and sold as easily as other ETFs
• Ongoing payments. Many bond ETFs provide regular dividends. This can create a passive income stream and is a simpler way to profit, as you’re not tracking individual bonds’ interest payments and maturities
• Cost-effective. Compared to bond funds, which are actively managed, bond ETFs are typically a more low-cost investment
• Instant diversification. When you invest in a bond ETF, you’re able to put your money into multiple bonds, sectors, locations and maturities in a single trade
• Lower minimum purchase. Bond funds often have a minimum investment amount that can reach the thousands. Corporate bonds are expensive to invest in and some require hundreds of thousands of dollars – not exactly chump change. With bond ETFs, however, there’s usually a much lower entry point. To invest in bond ETFs on the ASX and with Pearler, the minimum amount is currently $500
• Wide range of ETFs to choose from. The bond ETF market has evolved significantly (and continues to grow), meaning investors have many investments to choose from to suit different strategies

What are the potential drawbacks?

Despite their benefits, there are several risks well worth considering before investing in bond ETFs.

• You could lose your initial investment. Unlike traditional bonds – which promise to return your principal – bond ETFs offer no such guarantee
• Bond ETFs are still impacted by interest rates. Much like traditional bonds, bond ETFs can drop in value when interest rates rise – potentially resulting in a loss on your investment
• They’re subject to market volatility. Even if the bonds within an ETF remain stable, bond ETFs are vulnerable to periods of market volatility, either during the trading day or over a longer period
• You have less customisation. You might prefer to ‘pick and mix’ individual bond investments, taking advantage of varying maturities to stagger your income and being able to choose particular bonds that best suit your strategy

How could bond ETFs fit into different investing strategies?

Assuming they align with your investing strategy, bond ETFs can be a valuable addition to your portfolio.

Given the fact that they offer immediate diversification they can be an ideal way to access multiple holdings in a single trade – much like any other type of ETF. If you’re looking for a passive income stream or want to reinvest your dividends, the regular payments delivered by bond ETFs could be advantageous. And if you’ve adopted an ethical investing strategy, you’ll be glad to know several bond ETFs enforce ESG criteria. (But, as always, review the ETF in question to ensure they match your ESG criteria.)

Bonds are typically considered a defensive asset in that they’re fairly low-risk. In fact, many fund managers rely on them to help manage the risk associated with more volatile assets. So, if you’re adopting a risk-minimisation strategy like the core-satellite approach, you might allocate a bigger share of your portfolio to bond ETFs. On the other hand, if you’re looking for growth, bond ETFs may not deliver the high capital growth or index outperformance you’re hoping to achieve.

That being said, there are different levels of risk within the bond market, too, making some bond ETFs more appropriate for certain risk tolerances. Conservative investors may opt for safer bond ETFs that primarily invest in government bonds. Those who are comfortable taking on more risk for potentially higher returns may go for high-yield corporate bond ETFs.

Which bond ETFs are popular on Pearler?

Pearler offers a broad range of Australian and US bond ETFs that capture different types of bonds.

Some of the most popular include:

Australian bond ETFs

• iShares Core Composite Bond ETF (IAF). This bond ETF measures the performance of the Australian bond market and contains a mix of government and corporate bonds
• Vanguard Global Aggregate Bond Index (Hedged) ETF (VBND). VBND incorporates several bonds from around the world issued by governments and corporations
• Vanguard Australian Government Bond Index ETF (VGB). This bond ETF contains bonds issued by different levels of government in Australia, including federal and state
• BetaShares Global Gov Bond 20+ Yr ETF (GGOV). GGOV comprises long-maturity (20 years or more) bonds issued by governments from G7 nations
• BetaShares Sus Leaders Dvrsfd Bond ETF (GBND). GBND is an example of an ethical bond ETF, as it uses strict screening criteria to only include issuers which meet environmental standards

US bond ETFs

• US Total Bond Market Index ETF Vanguard (BND). BND aims to track the performance of the Barclays Capital U.S. Aggregate Bond Index, which measures a variety of bonds available in the US
• Vanguard Total World Bond ETF (BNDW). Similarly, BNDW tracks a range of bonds. However, its coverage is global and includes Europe, North America, the Pacific and emerging markets
• Vanguard Short-Term Government Bond ETF (VGSH). VGSH includes short-term (1-3 years) bonds issued by the US government and US treasury, as well as foreign debt guaranteed by the US government
• Short-Term Bond ETF Vanguard (BSV). Another composite bond ETF, this one includes both government and corporate bonds with a short-term maturity (1-5 years)
• SPDR Bbg Barclays International Treasury Bond ETF (BWX). This bond ETF tracks local currency sovereign debt of various countries excluding the US

What to consider before investing in bond ETFs

No matter what you’re investing in, it’s always worth doing your research first. Know exactly what you're putting your money into, understand the risks, and consider your own goals, strategy and investing horizon before diving in headfirst.