Bond exchange-traded funds (ETFs) have grown in popularity, and there have been some large inflows into some corporate bond and Treasury ETFs recently. In 2017, bond ETF inflows topped $100B. Investors seeking long-term income might find bonds useful. Now, if you don’t know already, the main risk inherent to bonds is interest rate risk. If you recall, typically, when interest rates rise, bond prices tend to fall, and vice versa. Although this doesn’t always hold true, if the markets are in a rising interest rate environment, it would be best to shy away from bonds. Let’s take a detailed look at some of the largest bond ETFs.
iShares Core U.S. Aggregate Bond ETF
The iShares Barclays Aggregate Bond Fund (AGG) is one of the largest bond funds, with over $44B in total net assets. Additionally, the ETF holds over 6,000 holdings and provides diversified exposure to investment-grade bonds. Now, the iShares Core U.S. Aggregate Bond ETF is an index-tracking fund and aims to provide investment results corresponding to the Bloomberg Barclays US Aggregate Bond Index. Now, the fund is fairly liquid with over 3M shares traded daily, on average.
The iShares Core U.S. Aggregate Bond ETF is primarily exposed to AAA rated bonds, allocating over 70% to bonds with these credit ratings received by S&P, Moody’s and Fitch. Keep in mind the credit ratings received by these firms are converted to the equivalent S&P major rating category. Therefore, the bond fund only carries a low to moderate degree of credit risk.
As stated earlier, interest rate risk is one of the primary risks when investing or trading bonds. One quick estimate to check the amount of interest rate risk inherent to a bond fund is to look at its duration. Keep in mind that the duration is not exact and the bond could fall more, or less, than expected. For example, the iShares Core U.S. Aggregate Bond ETF typically has a moderate degree of interest rate risk, as its effective duration is around 5-7 years. That means, assuming its effective duration is around 6 currently, if interest rates rise by an instantaneous 1%, then the fund should theoretically lose 6% in value, and vice versa.
That in mind, this is best suited for those who have a moderate degree of risk tolerance looking to earn some passive income or diversify their equity holdings with investment-grade bonds.
Vanguard Total Bond Market ETF
Vanguard Total Bond Market ETF (BND) is suitable for those seeking diversified exposure to the U.S. investment-grade bond market. The fund seeks to track the investment results of a broad-based and market-weighted bond index, the Bloomberg Barclays U.S. Aggregate Float Adjusted Index. However, this bond fund does not hold every security in its underlying index. Currently, the Vanguard Total Bond Market ETF holds over 8,600 bonds, with a yield to maturity of 2.6% and an average coupon of 3.1%. Moreover, it has an average effective maturity of 8.5 years and average duration of 6.1 years. Moreover, the fund has over $30B in total net assets. Additionally, the fund is relatively cost-efficient and only charges an annual expense ratio of 0.05%.
If you look at the fund’s underlying index, they both have similar characteristics even though BND does not hold all the securities in the index. The Bloomberg Barclays U.S. Aggregate Float Adjusted Index has over 10,000 bonds. However, its yield to maturity is 2.6%, average coupon is 3.1%, average effective maturity and duration is around 8 years and 6 years, respectively which are all, more or less, similar to that of the ETF.
Now, the fund offers a moderate degree of passive income, and its share value tends to have moderate fluctuations. Take note that his bond fund is catered more towards medium- or long-term investors who are looking for a reliable passive income stream, while adding diversification to an equity portfolio.
BND primarily allocates its portfolio to bonds issued by Treasury or Government Agencies, Government Mortgage-Backed and Industrial issuers. That in mind, it primarily holds U.S. government bonds, with over 60% allocated to that type of bond. Consequently, it has a low to moderate degree of credit risk.
These bond funds could be suitable for medium- to long-term investors who are looking to earn passive income, while diversifying their equity holdings. Keep in mind that these funds do carry interest rate risk, income risk and a moderate degree of credit risk. Now, these are not the only risks they may carry, but these are the ones that could affect the value of AGG and BND.
Jeff Bishop is lead trader at WeeklyMoneyMultiplier.com and widely recognized as the Mensa Trader. He runs short-term trading strategies, using stocks, options and leveraged ETFs.