The ABCs of Bond ETF Distributions

new etfsDistributions 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.

koya79 / iStock / Thinkstock

koya79 / iStock / Thinkstock

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.

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