Maximizing Returns and Mitigating Risk: The Benefits of Bond ETFs for Retail Investors in Fixed-Income Markets

Bottom Line Up Front

• Bond ETFs are an appealing choice for retail investors looking to invest in fixed-income markets.
• They offer potential inflation protection and higher yields compared to savings accounts.
• Bond ETFs provide easy access to fractional trading with high liquidity.
• Strategic reinvestment of dividends can result in significant long-term gains.

Fixed-income investing is increasingly on retail’s radar. Struggling equity and volatility spook many who started in the “stocks only go up” era of market exuberance. 

Since these traders and investors are somewhat familiar with debt markets, if only peripherally, they’re more sophisticated and look to squeeze the highest returns possible from their investments. Sometimes that means only a handful of BPS amid the resurgence in high-yield-savings accounts actually producing yield for the first time in years. 

So it’s little wonder they’re flooding fixed-income investing strategies. This investor class is taking advantage of higher rates, a newfound urgency to diversify, and the simple truth that even short-term Treasuries outperform the stock market.  

There’s a fatal flaw to fixed income, though. For those with tiny accounts or willing to devote a smaller slice of their cash to debt assets, sound strategies like bond laddering may be frustrating because they lack the action and liquidity of their favored stocks. 

There’s an alternative: bond exchange-traded funds (ETFs) offer diversified exposure to as many debt instruments as the investor wants to play with while taking advantage of most of the same upside as standard fixed-income strategies.

But bond ETFs also come with a hidden bonus. 

Why bond ETFs?

The core thesis behind bond ETF investing is the same as buying actual bond counterparts: inflation mitigation and yield, yield, yield.

Take back your yield

Yield chasing is a new concept for many retail traders, so it helps to visually picture why it’s such a hot topic. 

Source: FRED

The pandemic years were rough for broad fixed-income yields. Look at our green line, the 1-year T-bill, in July 2021: hovering at just above 0%, anyone stashing cash in Treasuries was playing a losing game.

So, it’s no wonder many retail traders and investors jumping into the market didn’t know, nor care, about yield: what’s a 0 – 4.5% yield mid-2021 compared to putting it all on black by picking a handful of 10x tech stocks?

Today, the collective yield is higher than in nearly a decade. Pay special attention to our corporate debt yield because that’s where we focus when we tell you the particular benefit of bond ETFs compared to clipping coupons.

Inflation

We all know inflation is hot, sticky, and not leaving us anytime soon (insert your own joke). Bond returns offset that inflationary effect on your cash to varying degrees, depending on which types you invest in. 

Many investors are confused because when they hear “cash position,” they think literally, as in a Scrooge McDuck-esque pile of bills sitting on the sideline waiting for a stock market rebound. So, imitating the pros advocating holding cash as an asset, they do precisely that. 

Whether under their mattress or dormant in their checking account, each dollar loses buying power by the day. Even cash sitting in a brokerage sweep account isn’t protected from inflation: many are startlingly limp and return even less than most interest-producing checking accounts.

That’s all to say that when big boys refer to a “cash” position, they’re actually cycling spare change into short-term Treasuries that return somewhere in the low- to high-4% range depending on maturity. 

So, while it isn’t perfect, investing in short-term Treasuries (in this case, 3-month T-bills) brings inflation’s impact from 6.6% to a more manageable 1.8% by way of a 4.8% return on our T-bills:

Source: FRED

ABCs of ETFs

OK, now to the good stuff. You likely know that ETFs comprise a basket of assets, whether stocks or bonds. Some ETFs, like sustainable investing, follow a theme, and some are simply pegged to a benchmark like the S&P 500. 

The primary benefit of ETFs for retail investors is that they represent an opportunity to invest in a part of something much larger than they’d be able to otherwise with a small account – you can buy around ten shares of SPY the same price it’d cost to buy just one share of each of the companies within that benchmarked ETF. Increased access to fractional trading serves to amplify ETF benefits. 

Bond ETFs function similarly.

Maximizing your money

Buying actual bonds, for some retail investors, isn’t ideal for two reasons: liquidity and the waiting game. Buying bonds means you’re locking up your capital for however long the security takes to mature; although secondary markets let you offload the asset, you may not have enough to meet the buyers’ minimum. Depending on price variance, you can even lose money (more on that soon). 

For this bond, you can’t offload the asset on the secondary market unless you have at least 250 to offer ($250,000 par value). Source: Fidelity

Unlike individual bonds, popular bond ETFs are as liquid as the rest of the market: you can find a buyer or seller with tight bid/ask spreads without too much of an issue, so liquidating your position isn’t a problem. Furthermore, there’s no maturation period to wait for – most bond ETFs issue monthly dividends.

Since many bond ETFs are pegged to a maturity-based benchmark (short-term junk bonds like SHYG, long-term US Treasuries like TLT), the fund constantly gets coupon payments from the bonds it holds as though you had a basket of the same securities maturing at the same time. Here’s what TLT’s distributions look like month-over-month:

Source: Morningstar

That dividend distribution series, while not perfectly aligned with the underlying benchmark’s yield (in this case, 20-year Treasuries), nevertheless stands in as a decent representative (both as of April 4th, 2023):

 TLT SEC yield: 3.73%

20-Year Treasury yield: 3.72%

Combined with how bond ETF pricing functions, monthly distributions are the secret to why they’re also a tremendous buy-and-hold investment today.

Upside and downside

Some retail investors may want to capture income from their bond ETFs, which is fine – 100 shares of SHYG, for example, got $26.30 this month. That’s slightly more than 8% annually, which beats any HYSA.

But reinvesting those dividends unlocks the next level of bond ETF investing.

Some newer investors may be surprised to see bond ETF prices essentially collapsing. “Why,” they ask, “has the price dropped more than 5% since the last year? I thought bond markets were hot?”

Source: Morningstar

To understand the interplay between the ETF’s price and yield, you must understand that bond prices and yields have an inverse relationship. If you buy a 20-year with a 4% coupon rate and hold the bond until maturity, then you aren’t worried about its price on the secondaries. Your yield is the coupon rate, ultimately. 

But bond prices rise and fall with actions and expectations, like the market. 

If you locked in your 20-year at 4%, but next month the US Treasury offers new issues at 4.5%, your bond’s price drops as the coupon rate is less than the new interest rate. That’s a substantial simplification, but remember this: old bond prices fall as rates increase. ETF prices are tied to the underlying bond’s pricing, so the ETF’s price falls for as long as rates rise. 

But your yield isn’t changing, so although you’re facing an apparent paper loss, the coupon rate doesn’t change. Your yield widens as the price drops and leaves you at a wash, more or less: 

Source: Morningstar

SHYG is a short-term junk bond ETF. The underlying asset in the fund is typically a zero-coupon security that generates yield via discounted issuance, but the point remains valid. 

As yields rose, SHYG’s price dropped. But, since those debt payments remained through maturity, the inverse effect cancels both out to squeak out a moderate net gain.

Income investors choosing to pocket the dividends and hold SHYG indefinitely rest assured that interest rate hikes will eventually halt or even be cut. In that case, the ETF’s price will return to the investor’s cost basis or beyond, although dividends will lessen. 

But we know that interest rate adjustments will eventually make today’s prices better than tomorrow’s: what if you reinvest dividends? 

By reinvesting dividends, you’re effectively buying the dip in bond prices and accumulating an increasingly substantial position primed to generate even more gains when rates stabilize. Let’s look at a quick hypothetical while remembering that past performance doesn’t guarantee future results. 

Buying the dip on bonds

Like stocks, SHYG got hit hard at the beginning of the pandemic in 2021 and fell 11% in March before eking out a 2% annual loss:

Source: Morningstar

Distributions remained stable, though, since the price drop was due to a sudden spike in yields before normalizing as interest rates dropped:

Source: FRED

Source: iShares

So, assume you went into 2020 with 100 shares:

• February 2020 value: $4643
• February’s dividend distribution: $18.9

Amid the cratered price, you’re looking at:

• March 2020 value: $4087 (-11.9%)
• March’s dividend distribution: $18.82

You either pocketed the 18 bucks in March or reinvested at the lower ETF price, buying 0.46 additional shares. By the end of the year, inflation made your dividend distribution squirreled under your mattress worth $17.98, but, reinvested is worth $20.98 at SHYG’s end-of-year $45.62 price.

That’s an 11% gain on a single distribution and 16% higher than you’d see the cash worth during the same period. 

Now look at today: SHYG is battered and hovers around $41 per share but gave the investor $26 this month to buy more shares. And more. And more. Every month.

We know that interest rate cuts will make SHYG’s price rise, so reinvesting those dividends and maintaining tactical patience means the difference between cash in your pocket today (which is nice) or compounding gains for months and years as your distributions buy more of the ETF each month it’s price stays suppressed. 

Oh, and did I mention that compounding effects mean that each month’s reinvestment leads to a higher total distribution the next? 

Unlocked potential

Very few assets increase dividends or cash returns as their value drops, so bond ETFs are a way to capitalize upon that unique feature of applying inverse price/yield relationships to a stock price for as long as rates remain elevated. And, yes, there’s risk involved when running the reinvestment strategy beyond interest rate risk bringing prices down further.

Credit risk, or the possibility of a bond issuer going bankrupt, is higher for bond ETFs like SHYG. The risk increases as the economy worsens. But, if you can afford to assume the risk, the yields will increase in kind as bond buyers get more return for a higher risk profile.

We’re facing a set of unique circumstances that demand new adaptations. Retail investors used to tech stock swings may shy away from debt markets or, if they’re interested, lack the capital and patience to buy new issues.

Buying bond ETFs is a remarkable stand-in for this investor class. If they can afford to maintain patience and wait out the Fed, though, they may generate far greater returns over the long-term than buying bonds themselves through the magic of compound reinvesting.