Which is Better: Buffered ETFs or Bond Funds?

"Hey Mike, when would I use a buffered ETF instead of a bond fund?” 

Discover how Buffered ETFs and Bond Funds could play a role in your retirement plan and/or portfolio.

Text your questions to 913-363-1234. 

Request Your Wealth Analysis by going to www.retireontime.com 

What is How to Retire on Time?

Welcome to How to Retire on Time, a show that answers your retirement questions. Say goodbye to the oversimplified advice you've heard hundreds of times. This show is about getting into the nitty-gritty so you can make better decisions as you prepare for retirement. Text your questions to 913-363-1234 and we'll feature them on the show. Don't forget to grab a copy of the book, How to Retire on Time, or check out our resources by going to www.retireontime.com.

Mike: 00:05

Welcome to How to Retire On Time, a show that answers your retirement questions. Say goodbye to the oversimplified advice that you've heard hundreds of times. This show is all about the nitty gritty. As always, remember, this is just a show, not financial advice, but you can text your questions to [phone], and we'll feature them right here. David, what do we got today?

David: 00:26

Hey, Mike. When would I use a buffered ETF instead of a bond fund?

Mike: 00:31

Yeah. So let's define what those are, just so we're clear as can be. A buffered ETF is kind of a newer product. I believe it became possible from a regulatory standpoint in 2018. So they haven't been around for a long time, but basically, it is an ETF that operates off of option contracts.

David: 00:53

Alright.

Mike: 00:53

So they don't actually buy the S and P 500 or the Qs or gold or whatever your buffered ETF is on. A buffered ETF is the simple ones are designed that basically, they're going to, through a contract, sell away the gains above a certain threshold to then turn around and buy protection for the downside.

David: 01:13

Okay.

Mike: 01:14

It's a very complicated thing I just said.

David: 01:16

Yeah. There's a lot of moving parts there.

Mike: 01:18

But think of an agreement. Let's say we're in the agreement here, and you put some money in here, and I say, great. We believe the market's gonna grow by 10 to 12%, but you're not really sure, and you just want 7% of that. Okay. So you know that there's three to five additional percent of growth that could happen over the next twelve months.

Mike: 01:38

You're going to sell the contract that if it happens, someone else can exercise their contract and capitalize on the three to 5% gains. So they haven't invested in the market. Just someone else has taken that upside potential. They've given you money for the right to enjoy those benefits if they were to happen. Not guaranteed, but if they were to happen.

David: 02:01

Mhmm.

Mike: 02:02

And then you take the money that you've earned off of selling away those those gains, and you go back and you buy protection from another person saying, hey. Look. Markets go up, like, six out of seven years. They'll probably keep going up. But just in case they go down, I'm gonna buy a contract from you that if they go down, you've gotta take the blunt of it.

Mike: 02:24

And they'll say, that's kind of expensive. You say, that's okay. Uh-huh. And then you buy the right to offload or sell basically the downside.

David: 02:33

Okay.

Mike: 02:34

That's how they work. That's how buffered ETF work. Now let's talk about what a bond fund is. Okay. A bond fund is not a bond.

Mike: 02:43

This is such a misunderstood concept. So bonds are protected as good as the they're protected as good as the creditor or agency or company that backs them.

David: 02:57

So what if it's like, I don't know, a school district who needs to

Mike: 03:00

Yeah. Municipal bond. Great. Is that bond gonna pay out? Are the taxpayers going to, you know, own up to it?

Mike: 03:08

Will it happen or not? Federal government treasuries, will they happen or will they not happen? Yeah. So a business, will they be able to make payments and then give you your thousand dollars back or not? Like that

David: 03:19

That's like a corporate bond then.

Mike: 03:20

Yeah. It's all kind of the same thing.

David: 03:22

Okay.

Mike: 03:23

The United States government treasury is considered one of the safer bonds. Municipal bonds may not be fully safe. They could default. Default means they missed a payment. It's not the end of the world.

Mike: 03:32

They missed a payment. It's now riskier, but hopefully you get most of your money back. Maybe you got all your money back by that one payment. Not that bad of a situation. It could be worse.

Mike: 03:42

But when you understand the bonds and how they are a contract, in some sense, a debt instrument Yeah. They're trying to raise money, so you give them your money as you're basically like a bank lender. That's how bonds work. And the bond market's the biggest market. It's way bigger than the stock market.

Mike: 03:58

Most people don't realize that.

David: 03:59

Yeah. We never really talk about it. Right? I mean, hear like, oh, the Dow was up, but we never hear about, oh, this.

Mike: 04:04

And I know Dave Ramsey hates all debt. I'd be interested to hear his opinion. He's well informed. He's not a stupid man. He's a very smart man.

Mike: 04:14

I don't always agree with his principles, but he makes really good points about how debt cripples a lot of people. Mhmm. I'm wondering what his opinion would be on businesses that use debt to grow. It'd be interesting because there are some things that businesses will do with debt to kind of manipulate their numbers and their share prices and so on. But anyway, that'd a fun conversation.

Mike: 04:36

So bond funds actively trade bonds.

David: 04:40

Okay.

Mike: 04:41

A bond fund is not guaranteed by an entity that backs it. So a bond fund can go down in value. Ah. So when would you use a buffered ETF versus a bond fund if you don't want any risk of it going down in value?

David: 04:57

Then I would use the buffered ETF.

Mike: 04:59

Might be more appropriate.

David: 05:00

Because the bond fund can go down on value.

Mike: 05:03

Yep. Now the theory behind bond funds is if the stock market goes down, bond funds should increase in value. Not always true.

David: 05:10

Alright.

Mike: 05:11

So there's two layers to this. One is that like we experienced in 2022 and 2023, the market was going down and they were jacking up interest rates. That hurt bond funds. But people think the correlation between interest rates and bond fund values, they're correlated. They're not actually correlated.

Mike: 05:29

They just rhyme.

David: 05:30

Is that kind of an industry jargon there with Yeah. Things rhyming?

Mike: 05:33

Yeah. If the Fed lowers rates, people expect bond funds to increase in value.

David: 05:39

Okay.

Mike: 05:40

And if the Fed increases rates, people expect bond funds to decrease in value. That's a whole thing unto itself. But the problem is that the Fed controls the cash market, not the bond market. The bond market is typically around the ten to twenty year treasury and what the market is willing to pay for it. So if the markets go down and there's a flight to safety, more people want to buy bonds.

Mike: 06:07

It's not as relevant to the Fed necessarily, but because the Fed may control short term bonds or short term instruments, there's an influence there, but it's not directly correlated. There have been times where the Fed lowers interest rates and bond prices or the the yield still increased. Because they're not actually correlated. They're not tied to the hip. Correlation means you can't separate it.

David: 06:32

Okay.

Mike: 06:32

Inversely correlated, correlated, they're not actually together.

David: 06:36

Okay.

Mike: 06:36

And so if you assume that a bond fund in a market crash would increase in value, that's a healthy assumption. Because the market's going down, you might want more bonds in your portfolio. If more people want more bonds in their portfolio, then there's a run to the bond market, so the values would increase.

David: 06:53

So typically, that's what would happen, but not always.

Mike: 06:56

It's not guaranteed, and that's the issue that I've got here is people say, well, my bond funds are are safe money. No. They're not safe. They're less risky money.

David: 07:04

Good distinction.

Mike: 07:05

So if you're looking for protection, you'd wanna go with a buffer ETF or maybe a CD or a bond itself.

David: 07:13

Okay.

Mike: 07:14

Or something that actually has structure, rigidity, and some sort of guarantee or version of a guarantee. If you think that bond funds would increase in value if the markets went down, then maybe a bond fund's more appropriate. Yeah. That's my 2¢. That's all the time we've got for the show today.

Mike: 07:31

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Mike: 07:57

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