Bond ETFs: What They Are and Why You Should Keep Them in Your Portfolio

Experts have long argued that bond ETFs should never be missing from a well-diversified portfolio.

These are now fairly widespread investment vehicles globally, which focus on bonds to offset the volatility of higher-risk assets such as stocks, acting as a shock absorber in multi-asset portfolios.

2024 is considered a record year for bond investments, with $600 billion flowing into global bond funds according to Reuters. The year has seen some of the highest returns in decades ahead of an uncertain 2025.

Falling inflation has finally allowed central banks to lower interest rates, prompting investors to lock in the relatively high yields available and finally kicking off “the year of bonds”, after $250 billion left fixed-income funds in 2022.

The two largest passive fund operators, BlackRock and Vanguard, have reaped the benefits. BlackRock’s iShares fixed-income ETF business alone attracted $111 billion in inflows between January and the end of October, according to Morningstar Direct estimates.

Vanguard’s bond funds have taken in about $120 billion, most of which has gone to its index business that includes ETFs.

In this context, knowing what are bond ETFs is essential for investors. Here’s how they work and why you should choose them for your portfolio.

What are bond ETFs

Bond ETFs are:

passively managed investment funds that invest in bond securities, such as government bonds or corporate bonds, to replicate their returns.

In essence, these instruments track the performance of an underlying index, for example the Bloomberg Barclays U.S. Aggregate Bond Index, to own a sample of the index’s bonds.

Bond ETFs are classified based on the issuer (government or company) and other factors, such as:

• credit rating: the higher the rating, the lower the risk of default
• maturity of underlying securities: the longer the average maturity of the underlying securities, the greater the volatility of the ETF, which can be negatively affected by rising interest rates;
• duration: an increase in interest rates reduces the value of the bond (and the ETF). For example, if rates rise by 1%, the value of a bond with a duration of 5 will decrease by 5%.
• currency: if the underlying is issued in a currency other than the euro, exchange rate risk must be considered

Bond ETFs are traded all day on a centralized exchange, unlike individual bonds. This means that they guarantee a certain flexibility and liquidity to investors.

Types of Bond ETFs

Bond ETFs can be divided into different categories, based on the type of bond they hold. In summary, these are the main types you can invest in:

• aggregate bond ETFs with selected government bonds and reliable investment grade;
• ETFs on Government Indices, sub-indices aimed at government bonds
• ETFs on Corporate Indices, bonds of companies with high volumes in the banking and institutional sectors;
• ETFs on Covered Bond Indices, referring to bonds covered and guaranteed by government and financial entities;
• ETFs on Inflation-linked Indices, relating to bonds linked to the trend of inflation. They guarantee a positive return in the event of growth in consumer prices;
• High Yield Index ETFs, which include high-yield and rated bonds that, however, carry a higher risk;
• Global Index ETFs, based on international bonds in multiple currencies and with potential exchange rate risk;
• Emerging Markets Bond Index ETFs, which refer to bonds that originate from emerging countries

Why invest in bond ETFs?

In general, analysts agree that owning funds allocated to bonds is a good investment strategy.

Bond ETFs tend to be more liquid and convenient than bond mutual funds and offer diversified bond holdings across a range of bond types, from US Treasuries to “junk” bonds.

Bond ETFs also guarantee monthly dividends based on the interest accrued on the bonds held in the fund’s portfolio.

These instruments offer immediate diversification and a constant duration, which means that an investor only needs to make one trade to start and manage a fixed income portfolio.

With the vast majority of ETFs replicating an index, it is always important to keep in mind that benchmark selection is an important decision for any investor, especially for bond investors.

According to expert assessments, for example, it can be a good idea to choose an ETF with a proven track record, which has demonstrated consistency not only in its construction, but also in its exposure over time.

“In order for investors to have the best chance of success” – explained Vanguard’s Rosti some time ago on Money.it – “I believe that in investing it is essential to take care in choosing the underlying index and the issuer of an ETF. Diversified and low cost bond index funds represent the best option for the vast majority of fixed income investors”.

The Benefits of Bond ETFs

Considering the characteristics of bond ETFs, there are several benefits for investors who choose them for their portfolios, such as:

• ease of management: a bond ETF pays the interest it receives on the bonds in its portfolio. This can be a good way to create an income stream without having to worry about the maturity and repayment of individual bonds;
• monthly dividends: some of the most popular bond ETFs pay monthly dividends, giving investors a regular income over a short period of time. This means that investors can calculate a monthly budget using the steady payments from bond ETFs;
• instant diversification: a bond ETF can offer you instant diversification, both in your portfolio and in the bond part of your portfolio. So, for example, by adding a bond ETF to your portfolio, your returns will tend to be more resilient and stable than a portfolio composed only of stocks. Diversification usually leads to lower risk;
• Lower Costs: Bond ETFs offer lower expense ratios than actively managed mutual funds.

Risks of Bond ETFs

Bond ETFs are a great option for gaining exposure to the bond market, but they can have some drawbacks.

First, an investor’s initial investment is at greater risk in an ETF than in an individual bond. Because a bond ETF never matures, there is no guarantee that the principal will be repaid in full. Additionally, when interest rates rise, they tend to hurt the price of the ETF, like an individual bond. Because the ETF does not mature, however, it is difficult to mitigate interest rate risk.

Bond ETFs are affected by variable interest rates, due to the impact on the bonds in their underlying portfolios. When interest rates fall, bond prices rise, and when interest rates rise, bond prices fall.

Both long-term and short-term bonds are affected by changes in interest rates, but long-term bonds are more impacted. Rising interest rates are one way you can lose money when investing in bonds.

Also, be aware of credit and liquidity risks. The former refers to the possibility that the issuer of the bond (which is a debt security) defaults. The latter translates into the potential difficulty of buying or selling bonds for an ETF in times of market stress.

How to choose the right bond ETFs in 2025

To understand if and how to choose bond ETFs to invest in in 2025, you must first summarize the economic and financial forecasts for the coming year.

There is no shortage of challenges and unknowns: the ECB will cut rates again probably with more conviction than the Fed, with the US performing on the economy and jobs compared to a still weakened Europe; Trump will officially take power with the threat of tariffs for all to be implemented; the wars in Ukraine and the Middle East could cause further shocks for raw materials and beyond; the US-China rivalry will be in the spotlight.

In this context, how should one orient oneself in investments? Is opting for bond ETFs the right move in 2025?

According to analysts, bonds, especially those with a high credit quality, provide a cushion to the portfolio. They are not perfectly correlated to stocks, as they are subject to the interest rate and credit risk rather than market risk. When stocks fall, bonds, especially Treasuries, have the potential to cushion your portfolio or even increase in value during a “flight to quality”.

Even if you have a high risk tolerance and aren’t relying on bonds for hedging, there are other good reasons to include them.

Lower-grade bonds or those in emerging markets offer higher yields, making them great for income seekers.

Actively managed US and Euro IG quality bonds have the potential to outperform over the next 12 months, according to analysis by Jason Xavier, head of Emea & Asia Etf Capital markets at Franklin Templeton.

Beware of some risks, though. Several factors could cause inflows to slow in 2025. President-elect Donald Trump’s tax cuts and deregulation agenda have caused US stocks to jump and equity inflows to rise, limiting the attractiveness of bonds.

Data from EPFR and TD Securities show that $117 billion flowed into U.S. equity funds in the four weeks after Trump’s Nov. 5 victory, more than four times the $27 billion invested in global bonds.

Meanwhile, investors are skeptical that corporate bonds can rally further after their strong performance this year.

Which ETFs to watch? Some of the most interesting funds, according to some strategists, include:

• Vanguard’s largest bond ETF BND, with more than $117 billion in assets. For a low expense ratio of 0.03%, BND tracks more than 11,300 investment-grade bonds represented by the Bloomberg US Aggregate Float Adjusted Index. The ETF currently has a yield to maturity of 4.7% and an average duration of six years;

• SPDR Bloomberg 1-3 Month T-Bill ETF: With a median 30-day bid-ask spread of 0.01%, BIL is one of the most liquid bond ETFs available. It pays a yield to maturity of 4.5% and charges an expense ratio of 0.1356%;

• Amplify Samsung SOFR ETF: Has very low price volatility, above-average liquidity, and charges a reasonable expense ratio of 0.2%.

Original article published on Money.it Italy. Original title: ETF obbligazionari: cosa sono e perché tenerli in portafoglio