ETFs September 22, 2015

    Bond exchange-traded funds (ETFs) can be a great way to diversify your portfolio; they can provide regular income and help counterbalance riskier, more volatile investments, like stocks. Here's an overview of bond ETFs: what they are, how they work and why you should consider them for your portfolio.

    Bonds vs. bond ETFs

    A bond represents a promise by a borrower—a company, government or some other entity—to repay a loan with interest. Bondholders typically receive that interest as a series of payments over the life of the bond, along with a promise to get the principal back when the bond matures, barring default. A bond ETF, on the other hand, owns a portfolio of bonds and is typically designed to closely track the performance of a specific fixed income index, like the global market or a specialized segment of the market.

    Bond ETFs can simplify investing

    Unlike stocks, which are traded on exchanges, individual bonds are traded directly between broker-dealers and large institutions. Bond prices are much less transparent than stock prices because they're revealed publicly only after trades are completed. Some bonds don't trade at all for long periods of time, and their last traded price may no longer reflect their underlying value.

    In addition, bonds are issued with different maturity dates, interest rates and other features. An investor seeking stock exposure to XYZ Company could simply buy XYZ common stock, but someone looking to invest in XYZ's debt could be faced with any number of choices, from short-term corporate paper to long-term bonds, all with varying interest rates and other conditions.

    ETFs can simplify bond investing by offering the following:

    • Ease of trading: ETFs are bought and sold on an exchange, like stocks. That means their price is visible throughout the day, making them more transparent than individual bonds. Broad-based ETFs can help create a low-cost, diversified portfolio that covers a large part of the fixed income market and aim to track the benchmark index.
    • Diverse choices: Bond ETFs come in all varieties. You can get broad market exposure with an ETF that tracks a major market index like the Barclays U.S. Aggregate Bond Index, which includes thousands of bonds backed by corporations, the U.S. Treasury, government agencies and mortgage pools. Or you can target narrower segments of the market—for instance, there are ETFs that own only short-term corporate bonds, utilities sector bonds or even German government bonds.

    Points to consider

    Here are a few things to keep in mind when investing in the bond ETFs.

    • Some ETFs have a wide bid-ask spread: This is the difference between what someone is willing to pay for a security at a given point in time (the "bid") and the price at which the market maker is willing to sell it (the "ask"). For frequently-traded bond ETFs, the bid-ask spread is typically relatively narrow because everyone basically agrees on what the security is worth. However, it can be difficult to assess the market price if the bond ETFs (or the underlying securities) don't trade very often. These uncertainties are built into the bid-ask spread, which can be quite wide. The wider the ETF's spread, the less cost-efficient it is to trade.
    • Tracking error should be minimal: A bond index often contains thousands of different bonds, with different maturity dates and interest rates—too many for an ETF manager to efficiently buy them all. In those cases, the manager will assemble a representative portfolio of bonds whose overall characteristics represent the index. If done properly, the ETF should track the benchmark fairly closely. If the ETF's portfolio doesn't replicate the benchmark very well, the ETF's performance could differ greatly from the performance of the index. Even ETFs that closely represent or replicate their index will have some tracking error due to fees, trading timing, etc.
    • You can lose principal: Individual bonds repay the principal at maturity, barring default. Since most bond ETFs never mature, the share price of a bond ETF can fluctuate with changes in interest rates.
    • Operating expenses can add up: Passively managed ETFs tend to be a lower-cost alternative to mutual funds. However, they do charge a fee to cover the costs of the fund, known as the operating expense ratio (OER). Individual bonds do not have an OER.

    The bottom line

    Bond ETFs can provide a steady stream of income and can help reduce portfolio volatility over time. Automated investment advisory services that employ bond ETFs, like Schwab Intelligent Portfolios™, can provide a low-cost solution for obtaining fixed-income diversification.

    How Schwab Intelligent Portfolios Can Help

    Schwab Intelligent Portfolios uses only ETFs with low operating expenses, minimal bid-ask spreads and relatively close benchmark tracking—all without charging commissions. To get started with a low-cost diversified portfolio, just answer a few questions about your investment objectives, timeline and risk tolerance, and Schwab Intelligent Portfolios will build and manage your portfolio.

    Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

    Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.

    Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

    Barclays U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis.

    Schwab Intelligent Portfolios™ charges no advisory fees. Schwab affiliates do earn revenue from the underlying assets in Schwab Intelligent Portfolios accounts. This revenue comes from managing Schwab ETFs™ and providing services related to certain third-party ETFs that can be selected for the portfolios, and from the cash feature on the accounts. Revenue may also be received from the market centers where ETF trade orders are routed for execution.

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