ETFs, or exchange-traded funds are made up of a group of stocks, bonds, or commodities and can be traded throughout the day. They are an alternative to buying individual stocks or bonds and have become increasingly popular over the last few years.
Fixed Income ETFs
Fixed income ETFs make up a portfolio exclusively of bonds. There are many reasons why investors decide to buy ETFs. Some investors buy fixed income ETFs with a buy and hold approach, and hold them for the long term, while others choose to take advantage of their trading ability and actively trade them. Others include them as part of a balanced portfolio to counter act the volatility of stocks. Fixed income ETFs provide a safe haven for investors since fixed income assets are generally less volatile and less risky than equity holdings. They often have an inverse relationship to stocks. When stocks go down, there is a flight to safety, and Fixed income ETFs usually benefit, with greater demand for the asset class.
Investors have a wide variety of choices among fixed income ETFs. There are very conservative options such as fixed income ETFs that hold short term U.S Government Treasury Bills and more risky fixed income ETFs that buy junk quality bonds. Other ETFs are made up of a mix of high quality and lower quality bonds issued by the U.S Government, Corporations, and local municipalities, with various maturities. Investors choose fixed income ETFs based on their appetite for risk, as lower quality bonds have a higher potential return, but greater level of risk.
ETFs have many advantages, which is why they have become very popular. Unlike mutual funds, which can only be bought or sold at the end of the trading day, one of the advantages of ETFs is that you can buy and sell them anytime throughout the trading day just like stocks. Market, limit orders, and selling short are all options with fixed income ETFs and allow the investor more control over their holdings and the way they trade. Fixed income EFTs also provide a low cost way for an investor to enter the bond market. While investing in one traditional bond typically requires a minimum investment of $1000, for the same amount that investor can invest in a fixed income ETF and get a much greater level of diversification all in a single investment.
From a tax perspective, ETFs are very efficient, and provide several advantages. In a traditional mutual fund you can have a tax liability from a capital gain even if you haven't sold the fund. With Fixed Income ETFs, the investor does not realize the tax liability until they sell their position in the ETF. ETFs offer this tax advantage because of a regulatory loophole called an in-kind trade, while mutual funds have to go into the open market to sell or buy their holdings. While it's a small technical difference, this loophole gives a tax advantage to ETFs. Most mutual funds distribute taxable gains in the 3rd or 4th quarter and many investors know this. As a strategy, they sell their fund position before gains are distributed and invest in ETFs. This can be an especially smart strategy if you have a tax loss. For example if an investor has a tax loss on a fixed income mutual fund, they can sell the position, take a tax loss, and invest in a similar ETF. This strategy can save you money on your taxes, and also puts you in a more tax efficient investment product.
