ETFs add risk to safe haven of bonds
The once risk-free place to park money and receive predictable return now comes with challenges
Bonds have always appealed to conservative investors looking for a safe place to park money while receiving a steady and predictable return.
Yet a growing number of investors are steering away from buying individual bonds because of the research required and the high cost of diversifying a portfolio. Instead, they are putting their money in bond exchange traded funds, which invest in many bonds.
Some financial advisers believe that might be a riskier move.
The value of a bond ETF goes up and down throughout the trading day like a stock and can be traded like a stock. Investors also could lose their principal.
“The challenge with bond ETFs is you are buying the debt in a bond ETF with little regard to the creditworthiness of the underlying bond issuers,” said Matthew Helfrich, president of Waldron Private Wealth in Bridgeville, Pa.
“If you have bond issuers who are already drunk on debt, you could — by buying their ETF — be giving them another drink.”
What makes bond ETFs more risky than individual bonds, which typically sell for a par value of $1,000 each, is that individual bonds have a fixed date at which they mature and investors get their $1,000 back.
Bond ETFs never mature because additional bonds are continually being bought and sold, therefore they can never offer the same protection for an investor’s initial investment.
And just by investing in the exchange traded fund, investors can be reducing the issuer’s creditworthiness, Helfrich said, adding that investors are adding money to a pool of funds that will be used by companies that may not be as creditworthy as buyers would prefer.
“Bond ETFs can be worthwhile for broad exposure to the bond market and the flexibility to trade, but you have to know exactly what you are doing,” Helfrich said.
With the U.S. central bank on course to continue raising interest rates for the foreseeable future, fixed-income investments, such as bonds, will be vulnerable. As interest rates rise, the value of existing bonds paying lower yields will fall as new bonds paying a higher yield gain value. But owners of individual bonds will still receive all of their principal when a bond matures, regardless of how high rates have climbed.
The risk of losing money has not stopped investors from embracing bond ETFs. Data from the Washington-based Investment Company Institute show the total net assets in bond mutual funds and bond exchange traded funds grew from $57 million (U.S.) in 2008 to $490 million in May 2017.
“The good news is that bond ETFs provide diversification, which is crucial. But the bad news is there are hidden landmines in bond ETFs,” said Andrew Stoltmann, a securities lawyer based in Chicago. “It’s very hard to do your due diligence on the quality of the bonds inside the bond ETF because there are so many.”
The same advantages and disadvantages apply to bond mutual funds, which are actively managed and often charge higher fees than bond ETFs.