Bond ETFs are popular and it’s important to understand why.
Even though you may not need or want bonds in your portfolio today, one day you will consider it and it is important to understand what is available and what fits into your strategy.
What are bonds?
Bonds are a fixed income vehicle for investors. It is a promise by a corporation (company, government, municipality, …) to pay you interest on a certain amount of money for a certain period of time.
In short, it is a fixed parameters loan. By the way, when trading there is also a secondary market for bonds, which is usually valued according to interest rates.
That being said, bonds don’t lose any money if you hold them to maturity. The dilema that investors must assess is whether their money is better with a GIC or a bond.
What is a bond ETF?
A bond ETF is an equity investment (the ETF) that focuses on investing in bonds as the underlying investment. The ETF could invest in other bond ETFs as well.
Take the Vanguard Global Aggregate Bond Index ETF (VGAB ETF), it invests in 2 Bond ETFs (VBU ETF and VBG ETF). Since the VBU is in turn a CAD hedged fund for currencies, it invests directly in BND. That’s 3 layers of ETFs before you actually invest in bonds.
ETFs are traded on the stock exchange like stocks. Investors are bidding on the ETF at a certain price and that is what drives the price of the ETF over the course of the day. Read this to understand the pricing of an ETF as opposed to NAV (Net Asset Value).
During the trading day there may be price fluctuations against the NAV. Here is another explanation of how the price of an ETF and the NAV can be adjusted to avoid a mismatch between the ETF price and the NAV.
Investors can temporarily over- or undervalue an ETF during trading hours as they are exposed to market prices. During the Covid-19 pandemic, most bond ETFs were negatively affected, although bond ETFs were seen as safe havens.
Back to what a bond is, bond ETFs aren’t as safe for your capital as actual bonds. It’s easier to access bond ETFs and have a fixed income representation, but the value still fluctuates according to the secondary bond market.
The best bond ETFs
Instead of making it easy to choose a bond ETF, we now have many options to choose from … too many options in fact, which can lead to confusion as to which bond ETF to buy. Let me simplify the selection for you.
The principle as an investor when looking for fixed income securities is to have the least amount of fluctuation. It’s not about building wealth, it’s about protecting it.
- The return should correspond to the income received. Growth is not important in bonds.
- Have the lowest fees.
- Invest as much as possible in the bond coupons directly.
- Invest only in Canadian bonds and avoid currency effects.
The table has been sorted according to returns since it was introduced. As mentioned earlier, we want the least variance over time, so we want low performance that is not intuitive.
Based on the data identified, the best bond ETF is the one with a return close to 3% since inception and a reasonable return based on holdings.
My choice is VGV – Vanguard Canadian Government Bond Index ETF.
- It focuses on high quality government bonds
- Has slight fluctuations
- Pays a decent return compared to GICs and interest rates.
The iShares CBO ETF and the iShares CLF ETF are closely in second and third place.
How to buy bond ETFs
It’s much easier to buy bond ETFs than it is to buy bonds separately, which is why they are much more popular.
To buy a bond ETF, you need a discount broker because ETFs trade like stocks on an exchange for ETFs. You indicate the number of stocks you want to buy from the selected ETF and whether you want to pay the market price or enter the price you want to pay.
I usually place a limit order with the market price just to avoid a mistake from the trading algorithm.
It happens that there are many discount brokers that offer access to free ETFs and you should use a discount broker with free ETFs whenever possible. Questrade is one of those discount brokers with free ETFs.