How to choose a bond ETF

• Level: For beginners
• Reading duration: 10 minutes

Choosing a bond ETF is the number one way to diversify your portfolio after you’ve bagged a global equities ETF. Bonds play defence while equities play offence. Bonds offer stability while equities offer growth. For these reasons, owning a bond ETF is key to bringing balance to your portfolio. But the bond market is huge and confusing. Not all bonds help us manage our risks. So we’ve written this guide to enable you to rapidly identify your ideal defensive partner from the vast range of bond ETFs out there.

Focusing your bond ETF choices

Step one is to focus our selection on the bond ETFs that best protect us against stock risk. Afterall, most people’s portfolios are dominated by equities. So our most important diversification move is to hold the defensive assets that are most likely to perform when the stock market is in retreat. And those assets are high-quality government bonds. High-quality means developed world government bonds that are rated investment grade and above. These bonds are the least risky type because they’re backed by the economic strength of strong and stable countries that are extremely unlikely to default on their national debt. Investors often flock to the comparative safety of government bonds during a recession because countries are much less vulnerable than companies during times of crisis. The surge in demand for government bonds pushes up their price, and cushions the impact of equity losses on your portfolio. This “flight-to-quality” effect isn’t guaranteed everytime but it often works. It’s the main reason why high-quality government bonds are good diversifiers of equity risk and are the core defensive asset class used in ETF portfolios.

Which high-quality government bond ETF?

A European investor should choose a Euro government bond ETF. A Euro government bond ETF holds a range of fixed income securities diversified across Eurozone countries. Why is it important to choose a Euro denominated fund? Because bonds that are not valued in your home currency expose you to currency risk. That adds unwelcome volatility to the defensive part of your portfolio. We want our bonds to improve portfolio stability so it’s best to eliminate currency risk from that side of the equation. We can safely ignore other types of bonds because they are typically not as good at diversifying equity risk as government bonds. So junk bonds, corporate bonds, emerging market bonds and the rest can all be crossed off our list. Inflation-linked bonds are a good option for a second bond ETF but we’ll come back to those. For now, let’s stay focused!

Choosing the right bond ETF maturity

Our next most important decision is to choose our bond ETF’s maturity. An individual bond’s maturity date works like a fixed rate savings account. If a savings account (or bond) has a maturity of three years then, at the end of that time, the issuer pays back the original amount of money loaned (also known as principal). In the meantime, the bondholder is paid interest as compensation for the risk they bear. Long loans are riskier than short ones which is why the bank pays more interest when you lock up your money for five years instead of one. The same is true for bonds. This fact of life leads to a helpful rule-of-thumb: longer maturity bonds are riskier than shorter maturity bonds of the same type. They should also be more rewarding (over the long-run). Keep that guideline in mind because it’ll help you choose the right ETF once we’ve covered the bond risk-reward trade-off. Now a bond ETF is diversified across a portfolio of bonds with many different maturities. As principal is repaid, the fund automatically reinvests that money in new bonds. (You can also choose to reinvest your interest payments, too.) The upshot is that a bond ETF normally expresses maturity as a range of years. For example, ‘7-10Y’. That means the ETF invests in bonds with maturities of 7 to 10 years. So just by scanning a bond ETF’s name you can intuitively grasp its level of risk and associated reward. The higher the maturity number, the higher the risk and the greater the potential return. The task now is to work out your personal risk-reward sweet spot.

Choosing your spot on the maturity risk spectrum

ETF maturity figures can be helpfully summed up as short, intermediate, or long bonds like this: Short bonds tend to be very stable – like cash. Long bonds can be very price volatile. At times they’ll be as wild as equities. Intermediates lie somewhere in-between. We’ll flesh out how they behave in a second. The bottom line is that longer maturity government bond ETFs experience greater volatility than shorter versions. That is, you’ll see a long bond ETF’s price fluctuate more in response to changes in interest rates, inflation, and other economic factors. Remember we don’t want to endure much volatility on the defensive side of our portfolios so the simple answer is to choose a short government bond ETF and be done with it. However, volatility can work for you as well as against. Nobody complains when our ETFs surge in price and this is a form of volatility, too. During a recession, longer-dated bonds may experience higher demand than shorter bonds because they’re often a better refuge during a storm. Looking back at these moments of crisis helps us understand how bonds behave and why they’re worth owning.

Putting it all together

Here’s a quick recap of the strengths and weakness of the three main bond maturity types: With long bonds gone, your final choice depends on your investment goals and circumstances. For example, an accumulating investor may decide that intermediate bonds offer a good balance of equity diversification and expected returns over the long run. However, a retiree is more vulnerable to inflation and needs to be able to withdraw funds from their portfolio without worrying about significant capital losses. So they may prize the price stability of short bonds above all else. If you want the best of both worlds, then you could always split your asset allocation between multiple bond ETFs – it all depends on your personal balance of risks.

Use our ETF screener to choose your bond ETFs

With the bond ETF essentials at your fingertips, you can quickly pull a suitable selection of products together using our data. Go to our ETF Screener to select from every bond ETF available in Europe. From the drop-down menu select:

• All asset classes > Bonds
• Region > Europe
• Bond Type > Government
• Maturity > 0-3 (Short bonds), 5-7 (Intermediate bonds) or 10+ (Long bonds)

(You can also choose a maturity figure of 3-5 for short bonds and 7-10 for intermediates.) Don’t worry about Bond Rating as all Euro government bonds are investment grade and above. Choose Social / Environmental from the Bond Strategy dropdown if you wish.

Compare your selection

The screener will automatically put your chosen ETFs into a tidy comparison table for you: We’ve selected 7-10 year intermediate government bond ETFs in the example above. (Check out how to compare your ETFs using the method outlined in How to choose a global ETF. This process works just as well for bond ETFs.)
You can quickly snip your longlist down to a short list by culling:

• New ETFs: any with less than 3 years of data
• High costs: chop any ETFs with a TER significantly higher than the rest
• Small fund sizes: ditch those below 100€ million
• Currency hedged ETFs: we’re using Euro denominated funds only

From your shortlist, choose the bond ETF with the right blend of features for you. Don’t just choose the ETF with the best performance when there isn’t much to choose between them. Small variations are probably just noise. Do use performance to weed out any ETFs that are significantly trailing the pack. Finally, check out the justETF ETF profile page for your top two or three choices. Read the fund literature on each ETF’s homepage too.

Alternative bond ETF options

A bond for life

OK, that’s a lot but hopefully this guide gives you the ammunition you need to search for your best bond ETF. If you’re new to investing and still finding your feet then it’s absolutely fine to start with a short Euro government bond ETF. You can always update your choice later as your confidence grows. Remember that diversification is the only free lunch in investing so just making the decision to pair your equities with a high-quality government bond ETF is already a great move.