You can buy ETFs based on a basket of corporate bonds or based on government bonds from a variety of countries.
Just as stock ETFs are designed to mimic the performance of the underlying stocks, bond ETFs are designed to correlate with the performance of the bond market. They offer individual investors the opportunity to trade the bond markets using their stock market trading accounts.
Bond ETFs, however, are not as good at mimicking their underlying assets as stock ETFs.
Why should this be so?
Here's a very simplified example of how bonds are priced and how, in the end, bond ETFs differ from the bonds.
Imagine the average CD account is paying 3 percent interest. You hold 100 government bonds you paid a dollar each for; they also pay three percent interest. So you receive $3 interest a year.
Then interest rates fall. The average CD pays now only pays 2 percent. The bond continues to pay you three percent. But if you wanted to sell the bond, the people buying it in the new interest rate environment would be paying for a two percent return. So how much would they have to pay? Two percent of $150 is $3. So the value of your bond has increased by fifty percent to $150. In addition to the small amount of interest the bond pays, you have also obtained a high capital gain.
However, as the bond reaches the end of its lifetime, when the bond issuer must redeem each bond for $1, the bonds will trade for closer and closer to $1 - even if earlier they traded for quite a different sum.
Bonds have finite life spans, but ETFs do not. They are based on the average value of bonds in whichever market they are shadowing. The result of this is that ETFs carry greater risk than bonds. At the end of its lifetime, a bond can be redeemed at its face value and hence, as the bond nears the end of its lifetime, the risk in holding the bond is small. Since bond ETFs do not reach an end, they do not exhibit the low risk that bonds have near the end of their lifetime. Depending on the situation, this can lead to bond ETFs outperforming or underperforming the actual bonds.
Unlike the underlying bonds, bond ETFs suffer the disadvantage of management fees. In the short term, this is evened out by lower spreads on transactions, but if you intend holding the bond ETF for some time, the management fees will outweigh the initial cost advantages.