When we are venturing into investment in securities❶ that involve lesser risk, we think of bonds and pooled fund investment. Pooled funds are basically individual funds that are consolidated together in a group. Let us look at two important groups of investment funds today – Bonds and ETFs or Exchange Traded Funds.
Bonds fall under fixed income securities❷ while ETFs can come under pooled funds, debt funds➌ and can also be considered fixed income securities based on their category.
You might be familiar with the term bonds, and if you are into hard-core investing, you might have invested in ETFs, or at least have heard about them. Let us see in this article what are the benefits of investing in bonds versus what are the benefits of investing in ETFs. We will also discuss the risks and demerits of each kind of investment.
However, before pitting Bonds against ETFs, let us first understand the terms in depth.
Note: In the end, you will find a glossary of terms that have been used throughout this article. The glossary has been included to make your reading easier and aid your understanding of the financial terms used.
A Bond is a loan paid to a government or private organization in lieu of an interest paid bi-annually or annually. When you purchase a bond of a public or a private company, you are lending money to that company. Usually, companies borrow to further growth of their business. The government and government bodies like the Municipality may seek borrowings in terms of bonds to build infrastructures like roads and schools.
When you purchase bonds, you are an investor to the company but you do not own a part of the company as share➍ -holders do. Bond-owners are creditors and have no say in or liability to the borrowing entity.
At the maturity of a bond, you get paid the principal sum back. The interest you are entitled to get paid in calculated periods of time, usually bi-annually.
There is no exchange➎ marketplace or a central place for bond trading. Bonds are traded mostly over the counter and through bond dealers. Bonds can also be traded privately between the borrower and the lender.
The bond market, though scattered, is huge worldwide. In India, the bond market is gaining more attention and has significantly grown in the last 5 years.
There are many kinds of bonds, but we can broadly categorize them in 2 major types :
Government Bonds : Bonds released by the Central and State Government, Municipal authorities and Public Sector companies come under Government Bonds. These bonds are also sometimes called Treasury Bonds.
Corporate Bonds : These bonds are issued by private companies to meet their growth target.
ETFs or Exchange Traded Funds, unlike bonds, are traded in exchanges. ETFs are a bunch of securities bundled together for trade. ETFs, like stocks, can be traded on a day to day basis.
The best way to understand ETFs is to think of a bunch of stocks➎ or bonds from different companies traded as a whole.
ETFs can comprise bonds or stocks of one particular industry segment, like IT, or can be a motley of bonds/stocks of different industries.
A better way to understand ETFs can be to liken them to mutual funds➏ . Indeed, mutual funds and ETFs share a number of characteristics. Let’s take a look.
- Both ETFs and Mutual Funds are better investment options for investors not interested in actively engaging in day to day market analysis and activity.
- ETFs and Mutual Funds focus on pooled investment options i.e they offer investment options on various industries or various companies of the same industry.
- Both ETFs and mutual funds are traded in exchanges.
- Both are managed by investment managers or brokers.
ETFs in India, fall into the following categories :
Bond ETFs may contain government or corporate bonds or both.
Index ETFs contain stocks of various industries.
Sector ETFs contain stocks of companies from a particular sector.
Gold ETFs trade in the bullion gold market. Bullion gold is mined gold that is 99.5% pure. The prices of the bullion gold rise and fall with the physical gold price. The price of Gold ETFs are based on the rise and fall of the bullion, and indirectly on the physical gold market.
Bank ETFs contain the stocks of banks.
International ETFs invest in stocks and bonds of foreign companies.
So where should you invest – Bonds or ETFs?
Now let us address the main question – where should you invest? Bonds or ETFs? To answer the question in a fair way, let us look at the benefits and drawbacks of each.
Benefits of Investment in Bonds
- Bonds are loans given to companies, and you get periodic interests on the loans. This very feature of bonds makes them less volatile than stocks.
- Bonds are beneficial for short and middle terms. Bonds are also beneficial in the sense that since it is a loan, you get back the principal amount after a set number of years. If you have a target of using your money for a particular spend in 2 years’ time, it is better to invest in bonds than going for a bank deposit, as the interest rate of bonds will be higher.
- Bond investment is especially beneficial for the older generation as there is a guarantee of the return of the principal amount.
- Having bonds in your investment portfolio❼ smooths-out the bumps offered by price variation of stocks.
Benefits of Investment in ETFs
- With ETFs, you can trade in stocks, gold, bonds and various kinds of securities with (comparatively) lesser risk attached.
- ETFs are traded on exchanges, hence there is more liquidity➑ attached to ETFs. This translates to ETFs being able to be traded throughout the day and can be sold short➒ .
- ETF broker rates are less, as they are passively managed. Passive management of securities means there is no active management (by a manager) on which securities to invest in. In a passive ETF investment, the money invested is put in all shares/bonds of all companies in that ETF category.
- ETFs are tax-friendly as they tend to realize➓ lesser capital gains❶❶ . Most ETF sells and buys are in-kind redemption❶❷ , and do not incur tax.
Disadvantages of Bonds
- Market Volatility ❶ ➌ : Bond interest rate is subject to market volatility. For short term bonds, interest volatility does not offer significant gains, as interest amounts fluctuate.
- Credit Risk : Sometimes companies face cash-crunch, and can default in interest payment. In the worst-case scenario, companies might be unable to pay the principal amount.
Disadvantages of ETFs
- Increasing Trade Fee : Frequent trading of ETFs during day trading will result in a rising trade fee. Add to that the brokerage commission on each sale and the cost of managing ETFs rise significantly.
Also, stocks of different companies have a different trading fee, so one can never be sure how much they are shelling out in the name of commission while selling ETF stocks.
- Market Volatility : Though comparatively stable than bonds and stocks, ETFs are also subject to market volatility and fluctuations. For example, Gold ETFs reflect the volatility of the physical gold market.
ETFs Vs. Bonds
We can compare Bonds and ETFs on the following parameters before drawing a conclusion of what is a better investment instrument.
Diversification refers to reducing investment risk by allocating funds to different investment instruments. In terms of diversification, ETFs offer a more diversified investment as stocks/bonds of many companies, and many industries can be invested on.
While both Bonds and ETFs carry lesser credit risk than stocks, the risk factor in bonds is higher as compared to ETFs.The diversification of ETFs makes it less volatile to sudden credit crashes. When some stocks or bonds crash, the others will still be paying interests or dividends.
Commission and Broker Fee
Bonds are actively or passively managed depending on how you want your broker or manager to handle bonds. ETFs are mostly passively managed. With ETFs, there can be different commissions attached to different stocks/bonds if active day trading is conducted. With both bonds and ETFs, the fee paid can be controlled if you do a little research before investing, and look at the prospectus closely for additional charges involved with buying and selling.
Fixed and Variable Income
Bonds pay out interest once or twice a year. Some ETFs pay dividends, but they are generally less compared to stocks. Also, bonds mature and pay back the principal sum. Most ETFs do not mature, and you may never get your principal sum back if you do not invest for a long period.
ETFs can be traded through your regular Demat account. The prices of ETFs are also displayed openly in the exchanges, making trade more transparent. Bonds are purchased through brokers, and there are chances of buying price discrepancy from broker to broker.
Let us also consider the topic of Bonds ETFs vs Bonds before we arrive at a solid conclusion :
- Bond ETFs comprise bonds of different industries or of a particular sector. Bonds are of only one particular company. In terms of diversification, Bond ETFs score better than bonds.
- Bonds mature over time but Bond ETFs generally do not mature. This makes bonds perfect for short and mid-run investments.
- Bonds pay yearly or bi-yearly interests. With Bond ETFs, since there are a bunch of bonds, you get interests paid almost every month.
- Bond ETF prices are more transparent as they are shown in exchanges. Bond ETFs can be traded during day trading hours just like stocks.
- Bond ETFs can be managed online through your Demat account. For individual company bonds, you need your broker for selling or additional bond purchases.
Our Verdict about Investment in Bonds and ETFs
We can safely conclude that both Bonds and ETFs have their respective place in an investment portfolio.
We strongly recommend you to invest in ETFs if you are :
- a beginner, and looking for a risk-free investment.
- planning for a longer-term investment.
- seeking a regular source of income in the form of interest.
- looking to reduce investment-related fees like brokerage and commission.
- want to start with a lesser amount for investment in securities.
Bonds are best for you if you are :
- seeking short term investment with higher interest rates than banks.
- know the bond market a little already, and have done your research before buying.
- ready to actively involved in finding the right deal in buying bonds since prices vary in the bond market.
- ready to invest a considerable sum in the securities market.
You need to remember that however risk-free, bonds and ETFs are not immune to market volatility completely.
A little amount of active interest periodically to assess the performance of your bond and ETF investments can go a long way in producing fruitful returns on investment.
GLOSSARY OF TERMS USED
❶ Securities : Securities are financial instruments or assets that can be traded for a monetary value.
❷ Fixed Income Securities : Fixed income securities are debt securities that pay a fixed income in the form of interests.
➌ Debt Funds : Debt funds are investment funds that have fixed income investment as their core investment.
➍ Shares and Stocks : A stock is a security that represents a part of the ownership of one or more companies. Stocks and shares have the same meaning, with stock being used in a more general sense. For example : I can have stocks in my investment portfolio, and I hold shares of ABC Pvt. Ltd. A share is more specifically used to refer to securities of a particular company. A stock is also known as equity.
➎ Exchange : An exchange is a central marketplace for buying and selling of financial instruments like stocks and Exchange Traded Funds.
➏ Mutual Funds : Mutual Funds are a kind of pooled investment where investors are pooled in to invest in various financial instruments like ETFS, stocks or bonds. Mutual Funds are best managed actively by a professional.
❼ Investment Portfolio : Your total assets or securities make up your investment portfolio. Just like your work portfolio shows your work experience, your investment portfolio shows your assets of investment. Like a work portfolio, your investment portfolio is best when diverse, and shows good returns.
➑ Liquidity : In investment, liquidity is the ease of trading securities for cash without incurring a loss.
➒ Short Selling : Short selling is an investment strategy wherein you sell off stocks anticipating a drop in stock prices, only to buy them back at the dropped price. The idea is to make a profit out of the buying back at reduced prices.
➓ Realize : Securities or stocks “realize” when they are sold in the market. Realized securities affect the tax structure of the investor. Securities can be sold ar a realized gain or loss.
❶❶ Capital Gains : When securities sell at a higher price than their purchase price, it results in a capital gain.
❶❷ In-kind Redemption : In-kind redemptions occur when you pay for new securities in terms of other securities instead of cash.
❶➌ Market Volatility : Market volatility refers to the uncertainty associated with the price up and down of securities like ETFs, stocks and bonds.