Matt’s Master Class: The ABCs of Bond ETF Distributions

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Welcome back to our master class on bond ETFs, where we go beyond the basics to help investors understand the mechanics and benefits of these innovative funds.  So far in this series, we've stayed pretty high level - covering the basic elements of bond ETFs , how they compare to stock ETFs and how they compare to individual bonds .  Today we're going to dive in a bit deeper as we discuss how bond ETF distributions work.

Distributions are an important aspect of a bond ETF because they represent interest payments from the bonds in the fund.  For some investors the interest, or coupon , is the main reason they're investing in bonds to begin with.  But receiving coupon payments from an individual bond differs from the experience of receiving distributions from a bond ETF, and that can sometimes cause confusion.

The first thing to understand is that a bond ETF distributes income in much the same way as a bond mutual fund.  In each case the fund passes through earned income, rather than actual coupons, to its investors.  Earned income reflects the yield at which the fund acquires each security.  Since bonds are typically sold at a higher or lower price than they were issued, their yields are often different than the stated coupon rate for the security.  When an ETF acquires a bond, it may have a 5% coupon, but the current yield may be 3% due to where the bond is currently trading.  That 3% is what is passed through to the fund's investors in the distribution payment.

As a '40 Act fund , a bond ETF is required to distribute all interest and capital gains to investors on at least an annual basis.  Most bond ETFs distribute interest on a monthly basis, which can provide a smoother income stream than the semi-annual coupon payments an individual bond typically provides (see hypothetical illustration below).

Illustration

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 ).

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog .  You can find more of his posts here .

[1] Source: Morningstar as of 12/31/2012




The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

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