Fixed Income Exchange-Traded Funds

Fixed income exchange-traded funds (ETFs), whose shares are traded on major stock exchanges, are a special type of mutual fund designed to track the performance of a specific bond market index. A bond market index is a statistical composite, created and maintained by a financial institution or financial information service, that tracks the performance of the overall bond market or of a specific sector (government, corporate, or mortgage-backed), maturity range or credit quality within the larger market. Different ETFs offer investors the opportunity to achieve broad or targeted bond market exposure.

Like bond market indices, ETFs are also created and managed by financial firms, but not necessarily by the same institutions that create and manage the index on which they are based. Common brand names for ETFs include iShares, SPDRs (short for Standard& Poor’s Depository Receipts, also known as “spiders”), Diamonds and Vipers. ETFs based on equity indices are more common, but some of these brands include fixed income ETFs as well. Each has different firms as sponsors and administrators. Unlike most bonds, ETFs generally trade on organized exchanges like the New York Stock Exchange or the American Stock Exchange.

Prices of fixed income ETF shares are affected by the same factors that influence bond prices:

• changes in interest rates (rising interest rates mean declining bond prices and vice versa)
• changes in yield spreads (the difference in yield between a U.S. Treasury security and another type of bond with comparable maturity)
• changes in the yield curve (the relationship among yields of bonds with different maturities)

Fixed Income ETFs usually distribute monthly dividends which can include both interest income on the underlying bonds and capital gains (if any). Most bonds pay interest semi-annually.

Unlike bonds, ETFs have no maturity date. Although bonds in the fund mature eventually, the proceeds are reinvested in new bonds rather than returned to investors. The only way for an ETF investor to get his or her principal back is to sell the shares. The price received may be more or less than what was paid, depending on the direction of interest rates and other bond market conditions in the interim.

ETFs trade on stock exchanges, whereas bonds are generally bought and sold through dealer firms. Trading on a stock exchange means that investors can execute trades just as they would with any listed stock. Also, price quotes and trading history for ETFs are available in the same manner as for listed stocks.

Furthermore, individual investors can execute trading strategies in ETFs that may be cumbersome using bonds themselves. For example, ETFs can generally be sold short just as any listed stock, and for most fixed-income ETFs, there are actively traded options chains available to individual investors. Short sales and options on individual bonds generally are not available to individual investors.

• Fixed income ETF shares are bought and sold on a stock exchange, while open-end mutual fund shares are bought and sold directly through the fund sponsor.
• ETF shares are priced continuously throughout the day, and traditional open-end mutual fund shares are priced once daily.
• ETF shares can be bought or sold at any time during the day. Open-end fund shares can only be bought or sold at the end of the trading day.
• ETF investors pay a brokerage commission on the trade, while traditional open end mutual fund investors may have to pay a sales charge or other fees to enter or exit the fund.
• Many open-end mutual funds are actively managed, meaning the portfolio manager makes investment decisions in an effort to enhance performance relative to the market as a whole. As a result, open-end funds tend to impose relatively higher management fees than passively managed (indexed) funds. ETFs are always indexed and tend to have management fees and expense ratios significantly lower than actively managed funds and in some cases lower than other index funds.