Bond ETFs are gaining investor attention. What to know before investing
Momo Productions | Digitalvision | Getty Images
If you're considering investing in bond exchange-traded funds (ETFs) rather than mutual funds, you're not alone. Fixed-income ETFs have attracted nearly $344 billion through October 31 this year, compared to $138 billion for fixed-income mutual funds, according to Morningstar Direct. This shift is part of a broader trend where investors are increasingly favoring ETFs. In October alone, mutual funds saw $74 billion in outflows, while ETFs attracted $166 billion.
While ETFs offer advantages over mutual funds, and bonds are generally seen as safer than stocks, experts emphasize the importance of understanding what you're investing in. Dan Sotiroff, a senior analyst at Morningstar, highlights the role of bonds in a portfolio, noting that they typically serve as a stabilizing force. The size of this role is something investors should determine themselves or with their financial advisor.
'Active management has a legitimate edge,' Sotiroff says. Active managers can bring unique insights and have a chance to outperform their benchmarks. The number of actively managed bond ETFs (511) has surpassed the number of passive bond ETFs (393), according to Morningstar. However, active funds come with higher expense ratios, with investors paying an average of 0.35% for actively managed bond ETFs, compared to 0.10% for passive funds.
Understanding the bonds you're investing in is crucial. U.S. Treasurys and corporate bonds with strong credit ratings are considered investment-grade, offering lower default risk. However, investment-grade bonds typically generate less income than riskier bonds. High-yield corporate bonds with lower ratings may offer higher yields but carry a greater default risk.
For retirement income, balancing income needs with bond portfolio liquidity is essential. Certified financial planner Tim Videnka, chief investment officer at Forza Wealth Management, emphasizes the importance of high-quality, liquid bonds. He notes that bonds can lose value, as seen in 2022 when the Federal Reserve raised interest rates, causing bond prices to slump.
The Federal Reserve's rate cuts in October were the second this year, but rates remain higher than pre-2022 levels. The fed funds rate, which affects mortgage, auto loan, and credit card rates, also influences bond and savings account interest rates. This dynamic highlights the importance of understanding market conditions and their impact on bond investments.
