The Characteristics of Bond ETFs

A bond ETF is a product that puts many bonds in one basket so they can be traded on an exchange in real time, like a stock. Its character changes depending on the kind of bonds it holds—government bonds, corporate bonds, short-term bonds, and so on.

The advantage is convenience. Individual bonds often have large minimum purchase units and are cumbersome to buy and sell, but a bond ETF lets you buy a bundle of bonds diversified across hundreds of issues for a small amount, all at once, and trade it anytime during the trading day.

But if you think it's exactly the same as an individual bond just because of the name 'bond,' a misunderstanding arises—because there's a decisive difference.

An individual bond has a maturity. If you hold to maturity (as long as the issuer doesn't default), you get the promised face amount back. Even if the price rises and falls in the meantime, if you hold to maturity there's an endpoint of recovering your principal.

A typical bond ETF, on the other hand, has no maturity. As the bonds it holds approach maturity, it sells them or swaps them for new bonds, continuously maintaining its target maturity, duration, and credit rating. Because it rolls forward endlessly, there is no 'maturity point at which you recover your principal.'

So the interest-rate risk that shrinks over time in an individual bond remains permanently in a bond ETF that has no maturity.

Bonds and interest rates are on a seesaw. When market rates rise, the prices of existing bonds fall, because bonds that already pay low interest become less attractive.

What summarizes this sensitivity in a single number is duration. Duration bundles various factors like maturity and coupon to tell you roughly how many percent the price will change when rates move 1 percentage point. The longer the duration, the more it swings with rate changes.

Because a bond ETF is priced in the market every day, rate movements are immediately reflected in the NAV. In fact, during periods when rates surged, long-term bond ETFs sometimes suffered large double-digit declines. Contrary to the conventional belief that 'bonds = safe,' during a rising-rate period a bond ETF can incur considerable losses.

Interest-rate risk: when rates rise, prices fall. The longer the duration, the greater the risk.

Credit risk: if the issuers of the bonds it holds can't pay principal and interest, losses occur. This risk is greater for corporate-bond and high-yield-bond ETFs.

Exchange-rate risk: overseas bond ETFs or dollar-denominated bond ETFs have FX movements layered onto returns. Domestically there are FX-hedged and unhedged types, so you must distinguish them.

A bond ETF is convenient and offers a diversification effect, but you should approach it understanding that, because it has 'no maturity,' it carries interest-rate risk continuously.