You may have heard on the news recently that prices of US Treasuries have been dropping.
At the same time, many inverse ETFs that are related to US government bonds have seen their yields hit new highs in 2023. As of October 31st, 2023, the best-performing bonds ETF has already gained nearly 54.14% since the beginning of the year.
As the investment world is full of opportunities, and there are many tools available that might suit current market conditions, knowledge is your greatest weapon for making money as an investor.
If you're not familiar with bond ETFs and how to choose one that may be right for you, this tutorial may help you understand what you need to know in just eight minutes.
1. What is a bond?
Let's start with a quick introduction to what bonds are.
Simply put, a bond is essentially an IOU. Investors lend money to the issuer, who promises to pay them fixed interest payments at regular intervals until the bond matures, at which point the principal is repaid. This certificate that pays interest and can be traded is called a bond.
Based on the maturity date, issuer, and credit rating, bonds can be categorized as follows:
By maturity date: Long-term Bonds / Short-term Bonds
By issuer: Government Bonds / Corporate Bonds
By credit rating: Investment-grade Bonds / High-yield Bonds (also known as Junk Bonds)
When investing in stocks, we become shareholders in publicly traded companies with growth potential, while when investing in bonds, we become creditors of governments or corporations.
Stock investors face the risk of drops in share prices, while bond investors face the risk of default when the issuer can't make scheduled principal and interest payments.
That's why the issuer's creditworthiness is critical in bond investing.
Generally, government bonds are safer than corporate bonds, especially in countries or regions with good economic conditions and high levels of development, such as U.S. Treasury bonds. After all, the risk of a country or region's government being unable to repay its debt is lower than that of companies.
Different countries and companies at different stages of development have varying levels of creditworthiness. How do we evaluate them?
Investors often turn to trusted rating agencies such as Moody's, Standard & Poor's, and Fitch for bond ratings.
In general, the higher the rating, the safer the bond is considered. Bonds with ratings of BBB or above (or Baa or above) are classified as "investment-grade bonds" which are generally considered relatively safe with lower potential returns.
On the other hand, bonds rated below these levels are known as "high-yield bonds" or "junk bonds", which carry a higher risk of default but also offer higher potential returns.
2. What features do bonds have?
Stable income
While stocks offer the potential for higher returns, choosing the wrong stock or timing may lead to losses. No publicly traded company guarantees the preservation of capital. Bonds, on the other hand, provide fixed interest at regular intervals if held until maturity, and obligate the issuer to pay back the principal at maturity. That's why bonds are also called "fixed income securities."
More security
If a company undergoes liquidation, bondholders usually have priority over equity shareholders when it comes to recovering assets. This makes bonds a generally safer choice than stocks in the same company. However, it's important to note that if the company is completely insolvent and there are not enough assets to cover all outstanding debts, bondholders may not be fully protected and could suffer losses.
Negative correlation with stocks
Research shows that since 2000, there has been a negative correlation between stocks and bonds in the US for most of the time. This means that when the stock market experiences a downturn, it's likely that the overall yield on bonds will rise. If stocks and bonds continue to remain negatively correlated, investing in both categories can help balance out account asset yields and potentially reduce risk.
3. Investing in bonds directly vs Investing in bond ETFs
If you're an individual investor, bond ETFs might be the way to go because they're more convenient. An important characteristic about bond ETFs is that you don't have to worry about choosing specific bonds. Instead, you can diversify by holding a basket of stocks at a lower cost than buying individual bonds.
Bonds and ETFs are two different types of investments. While you can hold onto an individual bond until it matures, an ETF is essentially a fund without an expiration date. So what happens when the bonds held by an ETF mature? The issuer of the ETF will sell those bonds and replace them with new ones, so there's no need to worry about the ETF itself expiring.
For instance, let's say you invest in an ETF that focuses on US Treasury bonds with maturities over 20 years. If the ETF holds some bonds with less than 20 years until maturity, the issuer will sell those bonds before they expire and buy new ones to keep the ETF's portfolio aligned with its objectives.
While this strategy aims to help the ETF stick to its goal, it also means that bond ETFs face greater interest rate risk compared to individual bonds. When interest rates drop, bond prices usually go up. When rates go up, bonds tend to decline. That's why when the Fed starts raising interest rates, the overall bond market generally reacts negatively.
Imagine you buy 10 bonds with a face value of $1,000 that mature in a year and carry a 1% interest rate. If you hold onto them until they mature, you'll get $10,100 in principal and interest. But let's say before they mature, the market interest rate goes up to 2%. Now, buying the same amount of newly issued bonds would give you $200 in interest after maturity - $100 more than your original interest. This means your original bonds aren't as attractive to other investors anymore. If you want to sell them, you'll have to sell them at a discount to make the transaction worthwhile to the purchaser.
But if your main concern is getting a stable interest, you can still hold onto those bonds until maturity.
Aside from these points, there are a few other differences between the two investments. For example, bonds typically pay dividends once or twice a year, while bond ETFs usually pay monthly dividends. And fees for bond investments include commissions and custody fees, while bond ETF fees are similar to stock trading fees, plus management fees.
Overall, both direct bond investments and bond ETFs are made for the long-term, but not so much for short-term trading (unless you're dealing with leveraged or inverse ETFs which are much riskier).
4. How to choose a bond ETF?
The first step is to choose a suitable bond ETF based on your risk tolerance and preference.
Open moomoo and tap on Markets > US > ETFs, where you'll see a wide range of ETFs.
For example, if you want to invest in US Treasury bonds, you can choose the Treasury Bond ETF category. In the list, you can select long-term or short-term bond ETFs based on your risk preferences. Generally, long-term bonds may face higher interest rate risks before maturity than short-term bonds.
If you have a relatively high risk tolerance and seek higher returns, you can check out high-yield bond ETFs or emerging market bond ETFs to see if there are any that interest you.
If you don't have a particular preference for bond types or don't want to spend too much time researching, you might consider investing in the entire bond market by selecting total bond market ETFs.
Next, you can compare the ETFs' details, such as holdings, liquidity, fees, and dividend yields.
Even if many bond ETFs track the same underlying, their holdings can vary significantly, which means their performance may also differ. Therefore, before investing, it's useful to compare their holdings.
In moomoo's ETF list, after selecting an ETF, tap "Fund" to see its holding details. For example, this is a snapshot of one ETF's detail page showing that almost all of its holdings are investment-grade bonds, rated BBB or higher, with most bonds maturing between 5-10 years.
Scroll down the page, we can also see which companies' bonds this ETF specifically holds. After reviewing this information, do you feel better equipped to evaluate this ETF?
If the bond types held are similar, we can further compare their market capitalization to assess liquidity and compare fees and dividend yields based on our preferences. All of this information is available on moomoo.
To summarize, here are the key points:
Bonds are a type of IOU. The major risk is the default by the issuer, so bond investors should pay attention to the credit ratings of issuers.
Compared to stocks, bonds have more stable returns and are usually safer. Generally, allocating both stocks and bonds is beneficial for portfolio stability.
Investing in bond ETFs allows investors to invest in a basket of bonds at lower costs than buying individual bonds, with more frequent dividends, and lower minimum investments. However, bond ETF prices are more sensitive to interest rate changes, and higher interest rates could lead to lower bond prices.
When considering an investment in bond ETFs, investors can first choose a category based on their preferences, then compare the ETFs' holdings and other details.
That's it for this lesson. Feel free to share your unique insights and discuss with us.
