Welcome back to our master class on bond ETFs, where we go beyond the basics to help investors understand the mechanics and benefits of these innovative funds. So far in this series, we’ve stayed pretty high level – covering the basic elements of bond ETFs, how they compare to stock ETFs and how they compare to individual bonds. Today we’re going to dive in a bit deeper as we discuss how bond ETF distributions work.
Distributions are an important aspect of a bond ETF because they represent interest payments from the bonds in the fund. For some investors the interest, or coupon, is the main reason they’re investing in bonds to begin with. But receiving coupon payments from an individual bond differs from the experience of receiving distributions from a bond ETF, and that can sometimes cause confusion.
The first thing to understand is that a bond ETF distributes income in much the same way as a bond mutual fund. In each case the fund passes through earned income, rather than actual coupons, to its investors. Earned income reflects the yield at which the fund acquires each security. Since bonds are typically sold at a higher or lower price than they were issued, their yields are often different than the stated coupon rate for the security. When an ETF acquires a bond, it may have a 5% coupon, but the current yield may be 3% due to where the bond is currently trading. That 3% is what is passed through to the fund’s investors in the distribution payment.
As a ’40 Act fund, a bond ETF is required to distribute all interest and capital gains to investors on at least an annual basis. Most bond ETFs distribute interest on a monthly basis, which can provide a smoother income stream than the semi-annual coupon payments an individual bond typically provides (see hypothetical illustration below).