How to Invest in US Fixed Income with Bond ETFs

Bonds are a type of fixed income that can make up a valuable part of an investment portfolio. They are generally defensive in nature and, particularly when using US bonds, can provide diversification to portfolios. So, what factors should you consider when looking for a fixed income ETF?

Let’s X-Plain:

  • What are the different types of US bonds?
  • What factors to consider when investing in bond ETFs?
  • Where do US bonds fit in a portfolio?

What are the Different Types of US Bonds?

Bonds are a common form of fixed income which help investors generate risk-adjusted returns, primarily through payments known as coupons. Read about income investing more broadly here. There are three primary types of bonds: government bonds (also called treasuries), investment grade corporate bonds, and high yield corporate bonds.

Global X has an ASX-listed ETF which has exposure to each bond type.

The below chart underscores the risk-reward dynamics of each bond type. Over the last two years, high yield corporate bonds have provided the highest yields, followed by investment grade corporate bonds and US Treasuries. This correlates to the amount of risk associated with each bond type.

Line chart showing yields on US dollar bonds have risen over the last twelve months.

What Factors to Consider When Investing in Bond ETFs?

Bonds – like stocks – have several metrics and characteristics which determine how they perform in different market conditions, and by extension, the role they can play in a portfolio.

What is a Yield Curve?

A yield curve shows investors the yields to maturity (defined below) of bonds with different maturity dates. It gives investors an easy way to compare the rewards for holding bonds for different periods of time. Generally, long-term yields are higher than short-term yields to compensate for the time risk, but sometimes the opposite occurs (known as an “inverted yield curve”).

What is Debt Outstanding?

Debt outstanding is the total face value of debt that a company, government or other entity has issued. The total value of debt may impact the amount of interest expense paid by a company, which can affect profitability. Normally bond index funds weight their holdings by the total debt outstanding, meaning those with higher levels of debt have higher weightings in the fund.

What is Duration?

Duration measures the extent to which a bond’s price responds to changes in prevailing interest rates. This matters to investors because it can impact the capital value of the bonds by a magnitude depending on the level of duration. Bond prices and interest rates have an inverse relationship, meaning a long-duration bond will see its price rise by a greater magnitude than a short-duration bond if interest rates fall.

What is Yield to Maturity?

Yield to maturity measures the yield an investor would receive if all the coupon payments of a bond were received, and the bond was held until maturity. This is generally a good indicator of the bond’s long-term return if the investor holds onto the bond until it matures.

What are Credit Spreads?

Credit spreads reflect the yield difference between two bonds (e.g. the difference between corporate bond yields and treasury bond yields). They offer investors insight into the additional yield they receive for assuming greater risk, serving as a gauge of the comparative value of the bonds.

What is Currency Hedging?

Currency hedging is where the price changes between two currencies – such as Australian dollars and US dollars – are mitigated using derivatives. It helps to remove the effects of currency volatility, making the bond’s performance the main driver of returns.

Where do US Bonds fit in a Portfolio?

Portfolio allocation is unique from investor to investor, but there are some “rules of thumb” which can be referred to in order to determine what kind of US fixed income allocation may be appropriate depending on factors such as risk tolerance, investment timeline, and cash flow goals.

Generally, bonds are used as a core fixed income allocation because they offer risk-adjusted returns, which are less volatile than stocks. Read more about core ETFs here. Another feature of bond ETFs is their yield which can work to generate portfolio or passive income.

As such, a larger allocation may be put towards US bond ETFs if an investor is seeking a defensive asset class with income potential. Meanwhile, a growth-oriented investor may have a smaller portfolio allocation to fixed income as it may not provide the desired outperformance or capital growth. Although bonds are widely viewed as a more defensive asset type, it does not mean investing in bonds is risk free. They are subject to factors such as market sentiment, central bank interest rate decisions, and the underlying performance of the original bond issuer.