Everything you need to know about bond ETFs

We have all heard the basic 60/40 rule: That 60 percent of your portfolio should generally be invested in stocks and 40 percent of your portfolio should be invested in bonds.

While it's somewhat easy to trade stocks — you simply buy or sell them on an exchange — it can be more difficult for the average investor to buy and sell bonds.

But having any percentage of bonds in your portfolio, 40 percent or otherwise, is a good idea because bonds can help provide income and some stability. There are a wide variety of investments that we can use to fill the space, but some investments are going to be more efficient than others.

Stock prices electronic display
Dowell | Getty Images

For that reason, let's take a look at the bond market as a whole. Individual bonds trade over the counter. This is very different from an exchange, where investors buy stocks.

If you want to buy a stock, you can do so pretty easily by calling your financial advisor or placing an order via your brokerage account online. You see the price where the stock is trading before you transact, which helps you determine if you want to trade and at what price.

In an OTC market, there is no exchange; buyers and sellers negotiate to agree upon a trade price. If you wanted to buy a bond, you'd have to contact individual bond dealers and find the one that's selling the bond you want to buy.

As a result, bonds can be hard to track down, and quotes from different brokers can vary widely; it's difficult to know if the price at which you traded a bond is fair.

Bond exchange-traded funds are portfolios of bonds that trade on an exchange like a stock. You see the price at which you can buy and sell the ETF, allowing you to better make an informed decision about your bond investment.

While some bond ETFs are actively managed, index-based ETFs — which generally seek to track the performance of an index — make up the majority of bond ETFs on the market today.

Some bond ETFs track a specific sector of the market, such as corporate bonds or Treasurys. Others will focus on credit rating or maturity. This gives an investor access to many different parts of the bond market.

Most bond ETFs are well diversified, holding hundreds of individual bonds, and provide a level of diversification that would be very difficult to achieve with individual bonds.

Two of the most common misconceptions about bond ETFs are that they're not run by a portfolio manager (they actually are) and that it is cheaper for an investor to buy individual bonds instead (not usually). Here's my take on all this.

FACT: Bond ETFs are managed by actual people. Sometimes people assume that because bond ETFs track an index, they hold all the securities in that index and there's no need for a portfolio manager.

The reality is that bond indexes tend to hold hundreds or thousands of bonds, some of which are thinly traded or illiquid. Thus, the PM must build and maintain a portfolio that seeks to track the index using the securities available.

Of course, if the PM is doing their job well, an ETF will just return the performance of its underlying index, and it may seem that they aren't doing much.

"Whatever 'golden rule' you use to build your portfolio, remember that fixed income plays a valuable role in building a more stable investment portfolio."

MYTH: It is cheaper to buy individual bonds. When you buy a bond, you generally just trade it at a price; there is rarely information about what commissions or other trading costs you paid. For this reason, some investors assume that buying a bond is free.

The reality is that there can be fairly hefty transaction costs, but they are baked into the price you paid, and you wouldn't see them unless you tried to sell the bond.

Standard & Poor's estimates that investors pay transaction costs of 1.27 percent when buying a municipal bond, and costs for other fixed-income sectors are similar. The transaction costs for bond ETFs are generally much lower and are actually visible to you when you invest.

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Just like stock, you can see both the ETF's bid price (where you can sell shares) and offer price (where you can buy shares) on the exchange throughout the day.

Whatever "golden rule" you use to build your portfolio, remember that fixed income plays a valuable role in building a more stable investment portfolio. When looking to invest, remember that ETFs can help you build an efficient and transparent portfolio.

— By Matt Tucker, head of iShares Americas Fixed Income Strategy at BlackRock