Bonds are considered a safe form of investment. What many do not know: ETFs can also be used to invest in bonds. They offer several advantages over buying individual bonds.
When it comes to ETFs, many investors think of a broad investment in shares, of a special fund that replicates a share index cheaply and automatically. How to invest with one Dax ETF, for example, in all companies in the most important German share index.
What many do not know: ETFs can also replicate other indices. A common variant are bond ETFs. Here you invest – analogous to the stock index – in all securities of a bond index, which bundles bonds from states or companies.
But how exactly does a bond ETF work? Should I invest in them? And what should I look out for when buying a bond ETF? t-online answers the most important questions about investing with bond ETFs.
How does a bond ETF work?
A bond ETF basically works like a stock ETF. The only difference: the index that the ETF tracks is a bond index.
But in order: Just like stocks bonds are also usually traded on the stock exchange.
Like stocks, they are also listed in indices there. For example, there is an index that summarizes the largest US corporate bonds. But there is also an index that only includes European government bonds.
In the case of a bond ETF, a computer algorithm tracks such an index. So when you invest your money in this ETF, you are investing in all bonds in an index. So you are basically lending money to any company or state whose bonds you invest in.
Bond ETF is another word for a bond ETF. The word “pension” is just another term for bonds, so it has nothing to do with your retirement savings. In this context, pension means a regular payment – here an interest payment for lending money.
What are the benefits of a bond ETF?
Bond ETFs have a number of advantages. The most important at a glance:
- risk: Since a bond ETF invests in all bonds in an index, it is broadly diversified. This reduces the risk of losing money if the price of a security crashes. The same risk requirements apply to bond ETFs as with individual bonds (see info box below).
- costs: Since, as with all ETFs, you don’t have to pay a fund manager to control the fund, bond ETFs are significantly cheaper than actively managed ones Pension funds (see below).
- Handy denomination: If you want to buy individual bonds, you usually have to invest 1,000 euros or more. The reason: Bonds are only issued in a certain denomination, the face value. In a bond ETF, on the other hand, you can invest with small sums – sometimes from 50 euros.
Bonds are generally considered a safe form of investment because their prices fluctuate less than, say, shares. They also generate a fixed interest rate. At the moment, however, they are hardly generating any income due to the low interest rates.
In addition, the following applies to bonds: The risk depends largely on the creditworthiness, i.e. the solvency of a country or company. This is determined by independent rating agencies. With a lower credit rating, the interest you get on a bond also increases. At the same time, however, the risk of losing your money also increases.
Why does a bond ETF price rise when interest rates fall?
As with bonds, there is also a special pricing logic for bond ETFs. Because the bond demand from investors – and thus the bond price – is determined by the so-called Market interest rate influenced. What is meant by this is the level of interest that the banks offer. The level of the market interest rate is based on the key rate of the central bank. In the EU, this is the European Central Bank (ECB).
When interest rates rise in the market, the interest rates on newly issued bonds go up. Investors would then prefer to invest their money in new bonds with the higher interest rate – and not in older bonds that were issued earlier and with a lower interest rate. The result: the price of older bonds falls – and so does that of the bond ETF.
Conversely, the same logic applies: if the market interest rate falls, the market price of older bonds rises. This also increases the price of the bond ETF.
Bond ETF or bond fund? What is better?
To decide between a bond ETF or a bond fund, you should know the exact difference. A bond fund is a mutual fund that actively invests in bonds. So here is a fund manager who specifically selects the bonds in which he invests the money.
A bond ETF, on the other hand, acts passively – a computer algorithm simulates a bond index. This is why a bond ETF is usually much cheaper. There are no fund manager costs.
As far as performance – and therefore returns – goes, a bond ETF is only as good as the bond index. But in most cases a fund manager does not manage to beat the development of an index price.
It is therefore difficult to say in general whether a bond ETF or a bond fund is better. The decision largely depends on what type of investing you are more comfortable with – and how much fees you are willing to pay.
What should I look out for when buying a bond ETF?
When investing in a bond ETF, there are several things to look out for. The most important at a glance:
- costs: How expensive is the investment? Here you should pay attention to the total expense ratio, the so-called “Total Expense Ratio”, or “TER” for short. As a rule, this is 0.1 and 0.5 percent of the investment amount per year for bond ETFs.
- index: Which index does the bond ETF track? The underlying index is decisive for how high the risk of the investment is. If an index only includes government bonds from emerging countries, the risk is higher that they can no longer service the bond. If so, you could lose your money.
- Course development: How has an ETF performed in the past? You cannot draw any direct conclusions from this for future performance – and thus your income. The past price development can, however, offer a point of reference for the investment decision.
- Distribution type: Should the interest be paid out or reinvested directly? In the first case, you should invest in what is known as a distributing bond ETF. However, you do not benefit so much from here Compound interest effect. Instead, the interest payments can be invested again immediately. In this case, you should invest in a so-called accumulation ETF.