Bond ETFs Explained – Don’t invest in the wrong ones

In this article we answer nine key questions on bond ETFs.

Exchange traded funds (ETFs) have revolutionised the investment industry. Nowadays, just about any body with a brokerage account can invest in a diversified basket of securities through ETFs.

Most people know you need to invest in stocks to grow your wealth over the long term. Less people know stocks work best alongside bonds.

Stocks do the heavy lifting, providing the big returns. Bonds provide stability. Yes, bond returns don’t usually measure up to stocks, but and it’s a big BUT, they don’t fall as hard and fast in the bad times.

In fact, if you invest in the right bond ETF it could even go up in value. But what about the wrong ones?

In this article we’ll answer 9 essential bond ETF questions so that you can avoid investing in the wrong bond ETF.

Let’s get into it.

1. What are short, intermediate and long bonds?

When you invest in bonds you essentially lend some entity money. Usually, a company or government. As with anytime you lend someone money there is a time period involved. How long until you get your money back.

Short, intermediate and long refers to these time periods.

Typically, with bonds we talk about this in terms of the average maturity of the bonds held in the fund.

The maturity is the length of time in years of the lending period.

Long = mid teens and above
Short = five years and below
Intermediate = those in-between

For reasons we are coming to different lengths of bonds tend to do well in different economic climates, which we can kind of summarise like this:

• When interest rates go up short term bonds tend to perform best
• When interest rates go down long term bonds tend to perform best
• When interest rates stay the same it doesn’t really matter which bonds you choose
• If sudden unexpected inflation occurs short term inflation protected bonds or short term bonds tend to perform best
• In an emergency short term bonds are your best bet

2. Why are bond ETF prices going down?

If bonds are going down in value. It is usually because interest rates are going up.

Bonds pay interest. These payments are based on central bank interest rates. When those go up. New bond interest payments go up too.

Who’d buy an older £100 bond paying 2% when you can buy a new one paying 4%!

Nobody likes it when the value of their investment assets goes down. However, there are two things to keep in mind.

First, this is usually a short term affair. Yes, the value of your bond ETF may go down, but because new bonds are constantly replacing older issues, you’re interest payments will be increasing. Over the long term these higher interest payments should more than make up for any short term losses.

In other words you’ll make more money in the long run if interest rates go up.

And second, if you really want to minimise this scenario or you are investing short term you can opt for a short bond fund, where new bonds replace older issues much more frequently.

3. When will prices go up?

The prices of bond ETFs usually go up when interest rates go down. That’s because newer bonds will have lower interest payments.

Would you sell your older bond paying 5% for a new one paying 3%. I don’t think so.

4. How do I choose an ETF?

There are three things to consider when choosing a bond ETF.

• Length
• Quality
• Currency

And it is worth looking at each of these in a bit more detail.

Length

The longer the bonds the higher the yield tends to be but the more interest rate risk you take on.

As we’ve already discussed, when interest rates go up, bond values go down. The longer your bonds the bigger you’ll be impacted. In fact long bonds can crash just as quickly and just as far as stocks.

And again, the key thing to remember is this is usually a temporary situation. The reason bond prices go down is because new bond yields are higher.

But bond ETFs are constantly replacing older bonds with new issues which have higher yields. Over the long term these higher yields should more than make up for any short term losses. You just need to be patient and in it for the long term.

Of course some people find it hard to be patient or are investing for shorter term goals. If that’s you go for shorter bond ETFs.

Quality

When you invest in a bond, you lend some money to some entity. As with anytime you lend money, there is always a risk you don’t get your money back.

With bonds this risk is described by credit quality.

The higher a bonds credit quality the higher the chance of getting your money back.

The reason some investors invest in lower quality bonds is because you usually get a higher yield. It’s a trade off.

If you want the best chance of getting your money back you should usually go for developed market government bonds, providing they are available in your currency.

Currency

Different countries use different currencies. In the US that’s the dollar. In the UK it’s the pound. If you invest in bonds of another currency to the one you use (or intend to use when you retire) you take on currency risk.

Currencies can be volatile. Year to date, the pound has weakened 20% against the dollar. If a US investor had their savings in pounds they would have lost 20% of their wealth. And just before you rush out and exchange your pounds for dollars, remember, the opposite could happen at any time.

So in practice if a UK investor wanted a super safe bond ETF, they should probably go for a short term, UK government bond fund.

5. How many separate ETFs do I need?

One bond ETF should be sufficient for most investors most of the time.

If you live in a developed country with high quality government bonds you can just invest those.

Expats who don’t know where they are going to settle can just invest in an unhedged global developed market government bond fund.

On the other hand if you regularly spend time in more than one country you might want to have a government bond fund for each.

If you live in a country without high quality government bonds you might want to mix it up a bit. Perhaps combine local bonds with a global developed market government bond fund or perhaps choose the bond fund of the nearest country with high quality government bonds.

Alternatively, some people like to have some exposure to US government bonds no matter where they live.

The argument is twofold. First, over the very long term most currencies are weakening against the dollar. And second, when stock markets crash, there is a rush to the dollar and mid to longer term US government bonds often go up in value.

In other words, if you have bonds in your portfolio purely as a counterweight to crashing stocks, having at least some of your bond exposure in the US may make sense.

6. Should I buy inflation linked bonds?

Probably not. That’s because the only inflation linked UK bond ETFs are really really really long.

In fact, they are just too long to work properly. Or to put it another way, they can crash hard, particularly when inflation hits and interest rates rise quickly ie the exact opposite of what a lot of people who buy them expect!

If you are really worried about inflation short term bond ETFs do a better job because older bonds are quickly being replaced with newer issues with higher interest payments.

7. Should I invest in emerging markets bonds?

Even though interest payments can be high, most investors probably shouldn’t shouldn’t choose emerging market (EM) bonds. EM bonds tend to be riskier than their developed market equivalent.

If you want to take on more risk, it’s probably better to do it by having more exposure to stocks.

So if your asset allocation is 50% stocks to 50% bonds, you could increase your stocks by say 10% meaning you now have 60% in stocks and 40% in bonds. (We’ve written more about asset allocation here.)

8. Are bond ETFs a good investment?

Bond ETFs are a great investment for many reasons. Here are the top 6:

• Convenience – When you buy shares in a bond ETF. All the work is done for you. All you have to do is click on buy in your brokerage account. And in fact, in many cases this can be automated too.
• Tax Efficient – ETFs are just about the most tax efficient investment product out there.
• Low cost – As you will see from the list in the next section, you can invest in a bond ETF for as little as 0.06%.
• Diversified – When you invest in a bond ETF you get a basket of bonds, meaning you avoid putting all your eggs in one basket.
• Accessibility – Anybody with a brokerage account can invest in a bond ETF. (We’ve covered brokerage accounts here for non residents and here for UK residents if you don’t already have one).
• Better returns – If you opt for index tracking ETFs your returns will be better than most professionals. (It might be worth a trip over to S&P Global if you don’t believe me).

9. What are the best UK government bond ETFs in the UK?

Here is a list of the best UK government bond ETFs.

It is based on you being resident in the UK or planning to retire back their. As a result, where global funds have been included they are hedged to the £.

If you don’t intend to retire to the UK you can purchase unhedged equivalents or those hedged to a currency you use or intend to use in the future.

Intermediate 

Invesco UK Gilts ETF (GLTA) TCO 0.06%
Lyxor Core UK Government Bond ETF (GILS) TCO 0.09%
Vanguard UK Gilt ETF (VGVA) TCO 0.1%

Long

SPDR Bloomberg Barclays 15+ Year Gilt ETF (GLTL) TCO 0.16%

Short

Invesco UK Gilt 1-5 Year ETF (GLT5) TCO 0.06% 
L&G UK Gilt 0-5 Year ETF (UKG5) TCO 0.06%
Lyxor UK Government Bond 0-5Y ETF (GIL5) TCO 0.09%
iShares UK Gilts 0-5 ETF (IGLS) TCO 0.1%

Index-linked

Lyxor Core UK Government Inflation-Linked Bond ETF (GILI) TCO 0.08% 
iShares £ Index-Linked Gilts ETF (INXG) TCO 0.14%

Global bonds (Government & Corporate) £ hedged

Amundi Index Global Aggregate 500M ETF (AGHG) TCO 0.09%
iShares Core Global Aggregate Bond ETF (AGBP) TCO 0.1%
iShares Global Aggregate Bond ESG ETF (AEGG) TCO 0.12%

Global government £ hedged

Amundi Index JP Morgan GBI Global Govies ETF (GOVG) TCO 0.17%
iShares Global Govt Bond ETF (IGLH) TCO 0.25%
Xtrackers Global Government Bond ETF (XGSG) TCO 0.29%

Global inflation-linkeds £ hedged

Lyxor Core Global Inflation-Linked 1-10Y Bond ETF (GISG) TCO 0.22%
iShares Global Inflation Linked Government Bond ETF (GILG) TCO 0.24%
Xtrackers Global Inflation Linked Bond ETF (XGIG) TCO 0.28% 

UK corporate

Invesco GBP Corporate Bond ETF (IGCB) TCO 0.15%
Invesco GBP Corporate Bond ESG ETF (IBGE) TCO 0.15%

Bond ETFs explained – Summary

• Bond ETFs are a great investment. Most people should have them in their portfolio.
• But they do have risks.
• The most common way to minimise bond risk is to go for short developed market government bonds denominated or hedged in the currency you use (or you intend to use in the future).
• If those aren’t available you may want to invest in multiple ETFs or a global fund.
• Anybody with a brokerage account can invest.