That ETF You’re Using Might Not Be All It’s Cracked Up To Be

Bond ETFs may be popular, but they’re far from perfect. Buying government or corporate bonds directly can give you some advantages that ETFs just can’t provide. With so many people looking to diversify their portfolios by adding a splash of bonds, it seems like a good time to take a look at the best ways to do that – and why you might want to avoid certain bond ETFs.

What’s the problem with the usual US Treasury ETFs?

The drawback of most bond ETFs is in the way they’re structured. And that’s certainly the case for the highly popular iShares 7-10 Year Treasury Bond ETF (ticker: IEF; expense ratio: 0.15%). This ETF tracks a group of US Treasury bonds with remaining maturities between seven and ten years. So, right now, it can only hold bonds that mature between February 2030 and February 2033. It sells its bonds when their maturities fall below the seven-year mark and reinvests the proceeds.

For example, its biggest holding – with a 19% weighting – is a US Treasury bond that matures on November 15th, 2031. It’s got a 1.375% coupon and was last traded at a price of $81.01, with a yield of 3.97%. That’s a really attractive bond. But by November of 2024, the ETF will have to sell it, because it’ll have less than seven years until its maturity.

And that goes against one of the key reasons to buy a bond: the fact that, at maturity, (in this case on November 15th, 2031), you can expect to receive its face value of $100, in addition to the interest payments from the coupon over the ten years – even if interest rates increase sharply in that year. It’s a guarantee that helps with financial planning needs.

And it’s a guarantee that’s not provided by the ETF.

So, if, let’s say, in early 2031, interest rates suddenly increase, the ETF would fall sharply – just as it did last year – because it would still hold bonds that mature in seven to ten years.

iShares 7-10 Year Treasury Bond ETF performance. Source: Bloomberg.

Where’s the opportunity then?

It may be worth picking just one or a few Treasury bonds with different maturities that match your financial needs. You can invest in newly issued US bonds directly from the US Treasury at TreasuryDirect or you can buy existing bonds through a brokerage account.

Alternatively, you could consider a bond ETF that specializes in very short-dated US Treasuries. These do have a real advantage for retail investors. See, these shorter-dated securities, known as T-bills, are generally available only to investors with access to huge amounts of funds. However, you can gain access through the iShares 0-3 Month Treasury Bond ETF (SGOV; 0.05%), which has a 4.7% yield, and the SPDR Bloomberg 1-3 Month T-Bill ETF (BIL; 0.135%), which has a 4.4% yield. Both look pretty attractive with interest rates appearing likely to stay higher for longer.

The drawbacks of ETFs invested solely in UK government bonds (gilts), such as the iShares UK Gilts UCITS ETF (IGLT; 0.07%), are similar to those in US Treasuries. Like in the US, you can buy and sell UK gilts directly from the UK Debt Management Office, which may even be a cheaper alternative than buying through your brokerage platform.

What’s the problem with the usual corporate bond ETFs?

Higher quality ETFs like the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD; 0.14%) or the iShares $ Corporate Bond UCITS ETF (LQGH; 0.25%) invest in a broad range of investment-grade corporate bonds. And that’s handy: it shrinks the single-company credit risk for an investor.

But because the bonds are issued by some top-shelf companies like T-Mobile, Goldman Sachs, JPMorgan, and AT&T, you could consider buying individual bonds with maturities that match your investment needs, rather than going for this ETF. See this fund has a similar risk as the bond ETFs: if interest rates move higher in the future, this ETF is probably going to take it on the chin.

These ETFs have also been criticized on another front too: at times of market volatility, the traded price of corporate bond ETFs has sometimes dropped to a much lower level than their Net Asset Value (NAV = value of assets). A good buying opportunity, maybe, but not a good thing if you’re already a holder.

iShares iBoxx $ Investment Grade Corporate Bond ETF Price and NAV. Source: Bloomberg

During the pandemic crisis in 2020, for example, the traded price (white line) of the LQD ETF was a lot lower – traded at a discount – than its NAV (blue line). That was likely because the liquidity of these investment-grade bonds wasn’t sufficient to deal with the extreme selling pressure of the ETFs.

Now, the discount did disappear once the market calmed down, but this risk is worth keeping in mind. If you bought a selection of corporate bonds, you could avoid this risk and also ensure you have bonds that match your financial planning needs.

Fidelity offers a full range of corporate bonds, both investment grade and (riskier) high-yield ones.