Bond funds and bond ETFs: differences, costs and selection criteria

• Bond funds and bond ETFs invest collectively in Bonds
• Asset class often develops in the opposite direction to stocks
• Rating agencies rate the creditworthiness of issuers from AAA to D

What sets bond funds and bond ETFs apart

Bond funds and bond ETFs are mutual funds that invest primarily in bonds. A bond is essentially a loan that investors grant to a government or a company. In return, you receive regular interest and the nominal value back at the end of the term. The value of such a fund is made up of two components: the interest income from the bonds it contains and their price development.

A key difference to stocks is their predictability. While stocks depend on company profits and losses, bonds offer a fixed term and usually a fixed interest rate. As the DKB explains in its financial knowledge portal, the often opposite development to stocks is particularly interesting: When the stock markets weaken, bonds can bring stability to the portfolio. Conversely, if key interest rates fall, the prices of existing bonds often rise as they become more attractive compared to new securities with lower interest rates.

Bond funds or bond ETFs: the differences

Although both variants invest in bonds, they differ in one key point: the type of management. As Raisin explains in a guide to bond funds, traditional bond funds are actively managed – a fund manager decides which bonds to buy or sell with the aim of achieving the highest possible return. The fund can be aimed at specific regions or segments, such as euro bonds, global securities or bonds from emerging markets.

This active support has its price: According to Raisin, the annual management fees for pension funds are between 0.5 and 1.3 percent. In addition, there is often an issue surcharge of an average of 3 percent when purchasing. Bond ETFs, on the other hand, passively replicate an existing bond index – without a manager actively intervening. The costs are correspondingly lower and are often only between 0.1 and 0.3 percent per year. Well-known indices that are tracked by bond ETFs include the Bloomberg Barclays Global Aggregate Bond Index for global government and corporate bonds or the iBoxx Euro Corporate Bond Index for European corporate bonds.

Another difference concerns tradability: bond ETFs are traded daily on the stock exchange and can be bought or sold at any time. Actively managed bond funds, on the other hand, can often only be traded through a broker or bank and are therefore less flexible.

Opportunities and risks at a glance

Both forms of investment offer the advantage of diversification: Instead of investing in individual bonds, investors spread their capital across many different securities – across different currency areas, maturities and credit ratings. Even smaller amounts can be invested in a broad bond portfolio.

However, neither bond funds nor bond ETFs are risk-free. Depending on the papers included, the risk profile can vary greatly. Funds with bonds from issuers with low credit ratings – for example from emerging markets – or with long remaining terms exhibit higher fluctuations. The risk of default also plays a role: If a company or state gets into financial difficulties, interest payments may not be made or the nominal value may not be repaid in full at the end of the term. For bonds with good credit ratings – such as government bonds from Germany or the USA – this risk is low. However, it increases significantly for high-yield bonds or securities from emerging markets.

As Raisin explains in a guide to bond ETFs, the general rule is: the higher the promised return, the greater the risk. When making a selection, investors should therefore pay attention to the risk class in the key information document, which ranges from 1 (low risk) to 7 (high risk). External rating agencies also assess the creditworthiness of the issuers – from AAA for highest creditworthiness to D for default.

There is another aspect with bond funds: the interest earned is usually paid out annually. This does not create a compound interest effect, as is possible with accumulating ETFs that automatically reinvest income.

Which variant is suitable for whom?

The choice between bond funds and bond ETFs depends on individual preferences. Anyone who relies on active management and is prepared to accept higher costs can rely on the expertise of a fund manager with a bond fund. This can react to market changes and try to achieve excess returns through targeted bond selection.

For cost-conscious investors looking for a transparent and flexible solution, bond ETFs are often the better choice. They replicate an index, can be traded on the stock exchange at any time and cause significantly lower ongoing costs. Regardless of the choice, both variants can serve as a stabilizing component in the portfolio – provided that investors pay attention to the creditworthiness of the securities included and choose a fund that suits their risk tolerance.

D. Maier / editorial team finanzen.net

This text is for informational purposes only and does not constitute an investment recommendation. finanzen.net GmbH excludes any claims for recourse.

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