So what are the mechanics behind the calculation of the distribution? Generally, an ETF accrues interest from the bonds it holds on a daily basis. Near the beginning of each month there is a record date, and anyone that holds the fund on that date is entitled to receive the next income distribution payment. That income distribution payment reflects the income earned by the fund since the prior distribution was made. Each of the fund’s investors then receives a payment based upon the number of shares that they hold, regardless of when they purchased the fund.
There are a couple of key things to note about this process. First, each fund share receives the same amount of income (e.g. 10 cents/share). And, like stock ETFs, a bond ETF’s net asset value (NAV) will decrease by the amount of the distribution.
While most bond ETF distributions are made up of interest payments, on some occasions a bond ETF may need to distribute long- or short-term capital gains to investors. This generally happens at the end of the year and is typically limited to one or two distributions. Just like in mutual funds, investors that hold the ETF at the time of the distribution are required to pay taxes on the capital gains.
However, historically bond ETFs have made smaller capital gains distributions than bond mutual funds[1]. Part of this is due to the ETF creation/redemption process which is more tax efficient than the cash subscription/redemption process used by most mutual funds (for more on the differences between ETFs and traditional mutual funds, click here). Additionally, a skilled ETF portfolio manager will work to minimize cap gains occurrences in the fund throughout the year (for more on how they do that, click here).
So what are the mechanics behind the calculation of the distribution? Generally, an ETF accrues interest from the bonds it holds on a daily basis. Near the beginning of each month there is a record date, and anyone that holds the fund on that date is entitled to receive the next income distribution payment. That income distribution payment reflects the income earned by the fund since the prior distribution was made. Each of the fund’s investors then receives a payment based upon the number of shares that they hold, regardless of when they purchased the fund.