Exchange traded funds [ETFs] are known for their ability to provide diversification, low cost alternatives, asset allocation and exposure to hard to reach markets and sectors. From a portfolio management and asset class perspective, bond ETFs do such a thing, however, it is equally important to understand the inherent risks involved with these versatile investment tools.

The first risk involved with bond ETFs is the risk of default. Bond ETFs hold actual bonds, which are promissory notes. So in essence, these promissory notes are only as good as the government, agency or corporation that issues it.

The second risk is interest-rate risk. If interest rates rise are higher than the coupon rate when a bond was purchased, then an investor is losing out and will have to sell his bond at a discount. One could hold the bond ETF to maturity, but that involves great opportunity cost. In general, the longer the maturity of a bond, the greater the interest-rate risk. For this reason, the iShares Barclays 20+ Year Treasury Bond Fund (NYSE:TLT) carries a substantially higher interest rate risk, while the iShares Barclays 1-3 Year Treasury Bond Fund (NYSE:SHY) carries very little, and are completely fixed income ETFs.

The third, and probably biggest, risk involved is inflation risk. This influences bond ETFs when the coupon rate on bonds held are 3% and inflation is 5%. There are bonds that are immune to inflation, such as the iShares Barcalys TIPS Bond Fund (NYSE:TIP), which is an inflation-protected bond ETF, but these fixed income ETFs carry interest rate risk and deflation risks. If prices start to drop, then an inflation adjustment will be worthless.

Bond ETFs are a key factor to a well balanced portfolio, but as with everything else, it is important to know the advantages and disadvantages that are involved.

Written By Kevin Grewal from Smart Stops 

Disclosure: Long TLT

Kevin Grewal serves as the editor at www.SmartStops.net, where he focuses on mitigating risk and implementing exit strategies to preserve equity. Additionally, he is the editor at The ETF Institute, which is the only independent organization providing financial professionals with certification, education, and training pertaining to exchange-traded funds (ETFs). Prior to this, Grewal was an analyst at a small hedge fund where he constructed portfolios dealing with stock lending, exchange-traded funds, arbitrage mechanisms and alternative investments. He is an expert at dealing with ETFs and holds a bachelor’s degree from the University of California along with a MBA from the California State University, Fullerton.

NYSE:SHY, NYSE:TIP, NYSE:TLT