ETF essentials · 2 minute read
Bond ETFs explained: how do they work?
The short answer
A bond ETF provides exposure to bonds—loans to governments, companies or other organisations. It can provide income and diversification, but its value can fall when interest rates rise, borrowers become less creditworthy or the bonds become harder to trade.
Why it matters
Most hold bonds directly; some use financial contracts to obtain bond-market returns. Check the replication method.
Bond ETFs are not all low risk. Their behaviour depends on the bonds they hold.
Important differences include:
- Issuer: government, company or another borrower
- Maturity: when the bonds are due to be repaid
- Duration: sensitivity to changes in interest rates
- Credit quality: the borrower’s ability to repay; investment-grade bonds have higher credit ratings, while high-yield bonds have lower ratings and greater default risk
- Currency: whether returns are exposed to foreign exchange movements
A short-term government bond ETF can behave very differently from a long-term corporate or high-yield bond ETF.
A simple example
If market interest rates rise, newly issued bonds may offer higher income. Existing bonds paying lower rates can become less attractive, causing their prices to fall.
A bond ETF holding longer-dated bonds will generally be more sensitive to that change than one holding short-dated bonds.
What to check
- Who issued the bonds?
- What are the average maturity and duration?
- What is the credit quality?
- Is the ETF government, investment-grade or high-yield?
- Is currency exposure hedged?
- How liquid are the underlying bonds?
Key term explained
Duration estimates how sensitive a bond or bond fund is to changes in interest rates. Higher duration generally means a larger price movement when rates change.
Bond ETFs can reduce some portfolio risks, but they do not provide a guaranteed return or guaranteed capital value.