Compared to the rest of the broad Exchange Traded Fund landscape, bond ETFs provide special benefits because they give investors access to the relatively illiquid over-the-counter bond market in the form of exchange traded shares. Compared to the advantages of stock ETFs, the cost savings of buying a corporate bond ETF over building the equivalent exposure through individual corporate bonds is large.

Most corporate bonds trade in the over the counter (OTC) market. Meaning that instead of having a centralized exchange, like the NYSE for stocks for example, a buyer of corporate bonds must find a current holder of the bonds who is willing to sell. The OTC model results in higher trading costs, and greater inefficiencies in the market, both of which are negatives for investors. While large companies usually have only one equity ticker, it isn’t uncommon for those same companies to have literally thousands of different bond issues currently trading in the market with different coupon rates, maturity dates and structures. Simply put, bonds are just altogether less efficient to trade than stocks, especially when individual positions get very small and many trades are needed for investors to diversify properly.

Corporate Bond ETFs trade on exchanges like stocks, and give investors the opportunity diversify properly, and gain passive exposure to the corporate bond market at a very low cost compared to buying individual bonds. As with all ETFs, corporate bond ETFs make great sense for very small dollar amounts. For the price of a stock trade, investors gain buy shares of CSJ, which tracks the Barclays 1-3 Year Credit Index, with an expense ratio of .2%.

But even when you consider much larger dollar amounts, the benefits of diversifying through a bond ETF still outweigh that of buying individual securities. For example; a $500,000 allocation to corporate bonds, spread out across a couple different ETFs, costs about $1,000 of expenses each year. Building an equally diversified basket of securities on your own, would require 50-75 initial transactions, giving you individual position sizes between $5-$10k, and a portfolio to rebalance and reinvest along the way. The intra-day liquidity of ETFs, along with the transaction cost savings of the pooled investment structure, makes $1,000/year on a $500,000 investment seem like a deal.

However, all corporate bond ETFs are different. The argument for or against high-yield (junk) bond funds is a discussion for a different day, so I will concentrate on the investment-grade corporate bond sector here.

The main differentiator between corporate bond funds is average maturity date. Shorter dated funds like CSJ and VCSH take less interest rate risk compared to longer funds such as LQD and VCIT. Using several corporate ETFs is an efficient way to maintain passive exposure to corporate bonds, while picking the level of interest rate risk you would like to take. A very important subject to consider in the current rate environment.

Generally speaking, expense ratios are the lowest on the Vanguard products, but there is more to consider when choosing between different options. Fluctuations above and below Net Asset Value (NAV) can drastically effect performance, and some ETFs trade more efficiently than others in that area. David Ott, a partner at Acropolis and regular contributor to Seeking Alpha, wrote a great piece on how market prices of bond ETFs can fluctuate around NAV and effect performance. I would suggest reading his post, Paying the Price for Bond ETFs: AGG vs. BND, if you are interested in the premium/discount dynamic.

There is a point where building a portfolio of corporate bonds makes more sense than paying a management fee for an ETF. Depending on the level of expertise and access to the OTC market for bonds, some investors could save money with a self-indexed strategy. But even for relatively large sums of money, there is value in corporate bond funds.

Have a great weekend.

Cliff J. Reynolds Jr., Investment Analyst