Pros and Cons of Bond ETFs

Bond ETFs are flooding the market but don't offer as many advantages as stock ETFs.
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Exchange-traded funds that track stock indices are among the fastest-growing investment products. Investors large and small are attracted by their low costs, liquidity and tax efficiency.

Some big players are betting that bond ETFs will be just as big a hit. So far this year, 19 fixed-income products have been launched, nearly quadrupling the number available in the U.S. to 25.

Last week State Street Global Advisors, a unit of

State Street

(STT) - Get Report

, launched three Treasury bond ETFs, an ETF that tracks inflation-protected securities and another that tracks investment-grade bonds.

Vanguard rolled out ETF share classes of four of its existing bond index funds in February; that followed on the heels of Barclays Global Investors, a unit of

Barclays PLC

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, which launched eight bond ETFs in January.

It's easy to see why: Bonds have a big place in most investors' portfolios, but the bond market is much less liquid that the stock market. So individuals who buy and sell bonds in small denominations end up paying a high price in terms of a wide spread between the bid and offer prices.

But bond ETFs may not be the no-brainer that stock ETFs are for so many people. One of the big advantages these baskets of securities offer over mutual funds is that you directly hold the securities that correspond to your shares. So you don't incur capital gains until you sell these shares. By comparison, mutual funds are pooled investment vehicles, and you can incur capital gains whenever the manager sells appreciated securities in this common portfolio.

Morningstar analyst Paul Herbert says the tax efficiency of ETFs simply isn't that meaningful to bond investors, because bond funds don't rack up sizable capital gains -- most of their returns are generated by interest payments. He notes that the

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Vanguard Total Bond Market Index (VBMFX) distributed just 9 cents of capital gains in the past decade.

Moreover, bond ETFs don't automatically reinvest these monthly dividends, and since ETFs are traded on an exchange, rather than issued and redeemed by their sponsors, you might have to pay your broker an additional commission if you want to reinvest the dividends. That could eat into your returns.

Another important advantage of ETFs is their low cost. But Herbert says that when it comes to investing in bonds, the differences between ETF fees and mutual-fund fees aren't as great as they are for stocks. Bond ETFs are still cheaper: Vanguard's charge an expense ratio of just 0.11%, while the expense ratios on State Street's range from 0.13% to 0.19% and BGI's range from 0.15% to 0.5%. By comparison, the average expense ratio for a bond index fund is 0.37%, while the average expense ratio for all bond funds -- both index funds and actively managed funds -- is 1.08%, according to Morningstar.

But Herbert says there are plenty of bond funds with expense ratios in the same range as the bond ETFs, and investors don't need to pay a brokerage commission to buy them.

"I think you have to think twice before looking at

bond ETFs," the analyst says. "They haven't made a strong enough case to supplant open-end funds of the index or active variety."

(To be sure, most actively managed bond funds are sold through brokers, who charge a sales commission, rather than directly to investors. That would tend to reduce the relative appeal of these funds, even when they outperform bond ETFs.)

For that matter, Herbert doesn't believe buying bond index funds is necessarily the way to go either. Research from Standard & Poor's shows that equity index funds beat actively managed equity funds 60% to 80% of the time. This is a good argument for investing in equities through ETFs, which also track indices but typically have even lower cost than index funds.

However, pricing in the bond market is so inefficient that it's easier for fund managers to earn their keep, according to Herbert. He says number of actively managed bond funds, such as


Pimco Total Return (PTTDX),

(MWTRX) - Get Report

MetWest Total Return (MWTRX) and

(WACPX) - Get Report

Western Asset Core (WACPX), have been able to outperform their indices over the past 10 years.

Neverthless, over the 10 years ended March 31, bond index funds still beat actively managed intermediate-term bond funds 89% of the time, according to Morningstar.

There's another potential drawback to investing in some of the new bond ETFs, however: They are competing with each other -- as well as with dozens of other ETFs that have been lauched recently and the hundreds still in the pipeline for assets, and for the attention of specialists who make a market in these instruments. That means they may not be as liquid as more established ETFs, and they could do a relatively poor job of tracking their benchmarks, particularly when prices move sharply.

In the first five months of this year, 149 new ETFs have been launched, and total assets in the market have risen 17% to $495 billion, according to Morningstar. But bond ETFs account for just a fraction of the total.

So why are so many bond ETFs hitting the market this year? Both State Street and Vanguard said that their bond ETFs had been in registration for years but the

Securities and Exchange Commission

kept sending them back to the drawing board. Now that the SEC is satisfied with the structure, investors can expect the floodgates to open.

Ameristock Funds currently has five bond ETFs in registration, and other ETF sponsors are believed to be working on similar products.

"I think this will be a great area for continued growth in 2008 and 2009," says Scott Ebner, the American Stock Exchange's senior vice president for the ETF marketplace. "ETFs are increasingly being used in asset-allocation models, and usually some part of that is allocated to fixed-income securities. I think we will see more ETF issuers come into the market and include fixed-income offerings as part of their product suites."

Herb Morgan, president of Efficient Market Advisors, an investment advisory firm in Del Mar, Calif., that makes portfolios strictly out of ETFs, says he's happy to have more fixed-income products to choose from. "The more the merrier," he says. "As long as there's volume and I can trade them, then I'm happy,"

Morgan adds, "However, if there is low volume, it causes grief and headaches. And there has been a slew of ETFs that don't have the volume for institutions like us to use them."