The ABCs of Bond ETF Distributions

koya79 / iStock / Thinkstock
koya79 / iStock / Thinkstock

Distributions are an important feature of a bond ETF, but the mechanics of how these distributions work can sometimes cause confusion. Matt Tucker brings us back to basics.

How do bond exchange traded fund (ETF) distributions work? It’s a question I get a lot. First, let’s explain what we mean by distributions. Distributions for a bond ETF represent interest earned from the bonds held in the fund.

For some investors the interest, or coupon, is the main reason they’re investing in bonds to begin with: the regular payments at set intervals. 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. Here are the things you need to know:

How a Bond ETF Distributes Income

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 percent coupon, but the current yield may be 3 percent due to where the bond is currently trading. That 3 percent is what is passed through to the fund’s investors in the distribution payment.

When the Distributions Take Place

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).

Hypothetical Coupon Payment of Individual Bond vs. Bond ETF

Hypothetical Coupon Payment

How the Distribution is Calculated

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.

The Treatment of Capital Gains

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, as shown below.

Average Capital Gains Distributions

Fixed Income Active Mutual Funds

0.3 – 0.5 percent

Equity Active Mutual Funds

5.0 – 5.5 percent

Fixed Income Index Mutual Funds

0.3 – 0.5 percent

Equity Index Mutual Funds

2.5 – 3.0 percent

Fixed Income ETFs

0 – 0.15 percent

Equity ETFs

0.15 – 0.3 percent

Source: Morningstar data as of December 31, 2014

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. Additionally, a skilled ETF portfolio manager will work to minimize cap gains occurrences in the fund throughout the year.

Do you have any questions about bond ETF distributions? Ask them below.

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.

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