With the plethora of investment choices out there, could fixed-income exchange traded funds (ETFs) enable one to maximize a portfolio’s performance?

The vast array of bond ETFs enable investors to grab exposure to international Treasuries, emerging market debt, Treasury Inflated Protected Securities (TIPS), convertibles and mortgage-backed securities.  You get the point – just about every aspect of fixed income has been covered by ETFs, giving investors the opportunity to diversify and reap the risk-reward benefits that traditionally come from equities, state Matt Hougan and Dave Nadig of Index Universe.

But…do they work?

  • Opponents of bond ETFs suggest that the premium or discount that they trade at from their underlying net asset value (NAV) is what deters them from trading them.
  • Advocates suggest that this characteristic is what enables investors to know the true value that one is willing to put on a basket of bonds.

Bond indexes aren’t set up like stock indexes. Bonds tend to trade just a few times each day, and there are some that may go days without trading. For that reason, bond indexes are calculated by using a combination of “actual bond trading prices and best-guess synthetic prices,” received from bond-pricing services.

It’s important to be mindful of the risks in bond ETFs. If the underlying holdings aren’t liquid (such as what happened with the iShares iBoxx High Yield Bond (HYG) ETF at the height of the credit crisis), it could cause the fund to drift from the NAV.

All that being said, bond ETFs do work as they should, and they can be a valuable component in any portfolio as long as investors understand the risks. Not all bonds and bond ETFs are created equal.

Meanwhile, bonds are as popular as ever. John Spence for The Wall Street Journal notes that bond ETFs accounted for 63 funds and $78 billion of the assets. Many expect this segment of the market to go through a major growth spurt now that PIMCO and others have entered.

For more stories on fixed income, visit our bond ETFs category.

Kevin Grewal contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.