Why Bond ETFs Are Bad and What You Can Do Instead

Bond ETFs can be a bad investment choice due to their high fees. Some bond ETFs charge management fees of up to 1.5% per year.

Investors often expect bond ETFs to provide a steady income stream, but many bond ETFs have a low yield, often around 2-3%. This is because the fees eat into the returns.

Investors can do better by investing in individual bonds, which often have lower fees and can provide a higher yield.

Bond ETFs are bad for certain asset classes, particularly corporate bonds and municipal bonds, which can become highly illiquid in times of financial disturbance.

This is because there are many more individual bonds than stocks, making it difficult to trade them at a fair price.

In contrast, open-end fund holders can always buy and sell at the 4 p.m. NAV, without such problems.

If you hold corporate or muni bonds in your portfolio, you might want to consider making sure you hold them in traditional mutual funds and not ETFs.

The only bond funds you should own are open-end municipal and corporate bond funds, as it's hard to put together a well-diversified low-expense mix of municipal or corporate securities on your own.

Vanguard offers a wide variety of national and state-specific mutual funds for munis, making it a clear choice.

The illusion of liquidity in bond ETFs is a major concern. This concept is rooted in the difference between stocks and bonds, with stocks being highly liquid and bonds being relatively illiquid.

Stanley Fischer, U.S. Federal Reserve Vice Chair, pointed out in a speech that ETFs offer daily or intraday liquidity to investors while holding assets that are hard to sell immediately, making them vulnerable to liquidity risk.

ETFs are designed to mimic an index, but applying the principles that relate to stocks to bonds makes little sense, especially for seasoned investors.

William J. Bernstein notes that the AP mechanism works well with stocks, but not with bonds, which can be highly illiquid. He uses the example of Ford Motor Company, which has a range of bonds with varying issue dates, coupons, and maturities.

During a financial disturbance, when liquidity becomes even thinner, most corporate bonds trade only "by appointment", which can lead to a significant disadvantage to the shareholder.

The open-end fund holder, on the other hand, can always buy and sell at the 4 p.m. NAV, without any such problem.

This is a major concern for investors who hold corporate or municipal bonds in ETFs, as it can lead to a sudden selloff and collapse of share prices.

If you're looking to diversify your portfolio beyond bond ETFs, consider individual bonds with lower fees. They can offer higher yields than bond ETFs.

You can also explore Treasury Inflation-Protected Securities (TIPS) for a hedge against inflation. TIPS offer a fixed return above inflation, but their yields are generally lower than those of traditional bonds.

Another option is municipal bonds, which are exempt from federal income tax, making them a good choice for tax-conscious investors. They often have lower yields than corporate bonds, but their tax benefits can make up for it.

Investing in a bond ladder can provide a steady income stream and help you avoid the risks associated with bond ETFs. A bond ladder involves buying a series of bonds with staggered maturity dates to create a regular income stream.

If you're willing to take on more risk, you can consider corporate bonds, which often offer higher yields than government bonds. However, they also come with a higher risk of default.