Ask Dave: How Do Bond Indexes Work?

A reader named Charles asks a very good question about how bond indexes work?

Quick question for you. I, of course, know how TIPS and bond works but what about a short-term bond indexes (XSB or XRB or TD e-Series) for instance? Does an investor actually gets coupon payment? (I dont think so…). Because the market value of the bond doesn’t change much, so the investor basically gets its return from the quarterly dividends only?

I have a good understanding about how bonds work myself although I don’t know much about the details of how bond indexes work although I sort of just imagine it as a basket of bonds with different dates of maturity, different coupon rates, and different face values, and that buying an index fund is just as if I had bought all the underlying bonds at their current face value. I will also receive all of the interest payments on the bonds in the index, or some of it will be reinvested into purchasing other bonds. That’s just my idea or assumption of how it must work.

Here is a short summary of how bonds work and how bond funds (mutual funds in this case, but an index should be no different in theory) from some website, but it is reprinted from American Century Investment Services, Inc.:

It’s easier to understand how bond funds work after you know how individual bonds work.

An individual bond pays interest at a rate set by the issuer. Usually, the issuer agrees to pay interest on a regular basis such as quarterly or semiannually. The current yield on a bond, which is the amount you earn, is calculated by dividing the amount of annual income by the bond’s price.

For example, if a $1,000 bond provides $80 in income, its current yield is 8% (80 divided by 1,000). Bonds pay interest income regularly and repay the face amount (principal) when the bond matures. Keep in mind that the price of a bond can change after it’s issued, which could change the current yield even though the interest rate stays the same.

With bond funds, the current yield also is referred to as the distribution yield, and it is calculated using the daily dividend per share. This is what is used to distribute income to the funds’ investors.

Another website called Quamut had a pretty good explanation of How Bond ETFs work:

Bond ETFs track indexes that contain individual bonds. Bond ETFs don’t have a face value or a coupon rate, however. Instead, bond ETFs have a share price that’s determined by the prices (face values) of the individual bonds in the index that the ETF tracks—when the prices of those bonds rise, the ETFs share price also rises. In place of a coupon rate, bond ETFs have a yield (interest payment) that equals the average interest rate of the bonds in the index that the ETF tracks. Though the interest payment on an individual bond is fixed, the yield of a bond ETF can change as the individual bonds in the index tracked by the ETF shift. Generally, these interest rates change only in small degrees.

If anyone else can find a better explanation out there please pass it on. So far the Wikipedia article on Bond Market Indexes is not great.

One thought on “Ask Dave: How Do Bond Indexes Work?”

  1. I got this answer from someone else:

    The investor receives a quarterly “Distribution” which consists of the interest coupons received by the ETF less the expenses of the ETF. At the end of the year a T3 slip is issued that will characterize the distribution as Box 26 other income (taxed the same as Interest income)

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