Income investors seeking competitive yields without taking excessive risk may find corporate bond ETFs attractive as the Fed started lowering interest rates and an economic soft landing appears achievable.
In the last two years, investors have enjoyed high-yielding money market funds and short-term Treasury securities. But as these yields begin to fall with cooling inflation, exchange-traded funds investing in corporate debt can be a smart alternative.
In this article, we provide a primer on corporate bond ETFs, as well as the pros and cons of investing them and a breakdown comparing corporate bonds to Treasuries bonds.
What Is a Corporate Bond ETF?
A corporate bond ETF is an exchange-traded fund that tracks either passively tracks an index basket of corporate debt securities or actively attempts to outperform an index benchmark. This makes these bond funds an accessible way for investors to gain exposure to the corporate bond market without having to buy individual bonds.
Corporate bond ETFs can target specific sectors (e.g., financials or industrials), credit quality (investment-grade or high-yield bonds), or maturities (short-term or long-term). This flexibility makes them appeal to a wide range of investors.
When considering corporate bond ETFs as part of an investment strategy, it's important to weigh their benefits and potential drawbacks. These ETFs offer diversified exposure to the corporate bond market, providing income and accessibility for investors. However, like any investment, they come with specific risks, including interest rate sensitivity and credit risk.
Pros
Diversification: ETFs offer exposure to a broad basket of corporate bonds, reducing the risk associated with individual bond defaults. For investors with smaller capital, this level of diversification would be difficult to achieve by purchasing individual bonds.
Liquidity: Corporate bond ETFs are traded on exchanges, providing intraday liquidity, which means investors can buy or sell them at any time during market hours, unlike individual corporate bonds, which may have less frequent trading and higher transaction costs.
Accessibility: ETFs lower the barrier to entry for retail investors, providing access to the corporate bond market without the need for deep expertise or large sums of money.
Lower costs: ETFs typically charge lower management fees compared to bond mutual funds.
Income generation: Corporate bonds generally offer higher yields and greater long-term returns than government bonds (like U.S. Treasuries), making corporate bond ETFs an attractive option for income-seeking investors.
Cons
Interest rate risk: Like all bond investments, corporate bond ETFs are sensitive to changes in interest rates. When interest rates rise, the prices of existing bonds typically fall, which can hurt the value of the ETF.
Credit risk: Corporate bonds carry the risk that the issuing company may default on its debt payments. While investment-grade corporate bond ETFs have lower credit risk, high-yield (or "junk") bond ETFs can expose investors to significant credit risk.
Liquidity risk: While the ETF itself may trade on an exchange, the underlying corporate bonds may not always be highly liquid, especially during times of market stress. This could lead to larger bid-ask spreads or difficulty in buying/selling shares at fair market prices.
Market volatility: Since ETFs are traded like stocks, their prices can fluctuate during the day based on market sentiment, which might not reflect the true value of the underlying bonds.
Corporate Bonds vs. Treasury Bonds: A Comparison
Investors may choose between investing in corporate bonds or Treasury bonds (through ETFs or directly). Here’s how the two compare:
Corporate Bonds
Corporate bonds are debt securities issued by companies to raise capital, and when investors purchase these bonds (through ETFs or individually), they essentially lend money to the companies in exchange for regular interest payments (coupons) and the return of the bond's face value at maturity.
Treasury Bonds
Treasury securities are debt instruments issued by the U.S. Department of the Treasury to finance government spending. These securities are considered one of the safest investments because they are backed by the full faith and credit of the U.S. government.
Treasury securities come in various forms, including Treasury bills (short-term), Treasury notes (medium-term), and Treasury bonds (long-term), each with different maturities and interest rates. They pay periodic interest and return the principal at maturity, making them a popular choice for risk-averse investors seeking stability.
Key Takeaways on Corporates vs. Treasuries
Yield vs. safety: Treasury bonds are safer, but they offer lower yields. Corporate bonds provide higher yields but come with additional risks, including credit risk.
Risk tolerance: Investors looking for safety and a hedge against economic downturns often prefer Treasuries, while those seeking higher returns and willing to accept more risk may choose corporate bonds or ETFs.
Liquidity: Treasuries are more liquid, making them easier to buy and sell without significant price impact.
For those seeking a balance between yield and safety, a diversified portfolio including both corporate and Treasury bond ETFs may provide the best of both worlds.
Corporate Bond ETFs in 2024 and 2025
In a falling rate environment, corporate bond ETFs can provide a good alternative to high-yield money market funds and short-term Treasury securities, as interest rates for the latter tend to fall in this environment.
However, should economic conditions deteriorate further than expected, and a recession ensue, corporate bond ETFs with greater credit risk, such as junk bond funds, can experience price declines.
Thus, for cautious investors that want to invest in corporate bond ETFs, investment grade or higher credit quality can be a more suitable choice.
