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Investing in individual bonds can be complicated, but exchange-traded funds (ETFs) that invest in bonds — a.k.a. bond ETFs — can provide a more straightforward way to invest in fixed income securities.

Investors may associate ETFs with stocks, thanks to the popular ETFs that track stock indices like the S&P 500. ETFs also happen to trade on stock exchanges, like the New York Stock Exchange.

Bond ETFs work similarly. Though the ETF holds bonds and not stocks, it trades on a stock exchange. Said another way, a bond ETF is a bundle of bonds that an investor can trade like a stock.

Bond ETFs make it possible for investors to buy a diversified set of bonds, without the time and effort it would take to build a portfolio of individual bonds.

Before getting into the specifics of bond ETFs, it will be helpful to understand ETFs and bonds separately. Let’s begin with ETFs.

ETF 101: Reviewing the Basics

An investment fund provides a way to pool money with other investors so that money can then be spread across many different investments (sometimes referred to as a “basket” of investments).

For most small investors, it would be too costly to individually purchase 500 individual stocks or 1,000 individual bonds. But such a thing becomes possible when doing it alongside thousands of other investors. Though different vehicles, mutual funds and ETFs provide investors with an incredible opportunity to diversify their investments.

For retail investors, investment funds come in two major varieties: mutual funds and exchange-traded funds. Mutual funds and ETFs are constructed differently — ETFs were built to trade on an exchange, as the name implies — but both can be useful tools in gaining broad diversification.

Whether investors will choose a mutual fund or ETF will likely depend on their preference, and context. For example, someone using a workplace retirement plan may only have access to mutual funds, so that’s what they use.

Someone who is investing independently may choose ETFs, because it’s possible to purchase them without any of the normally associated trading costs.

Whether an investor is using a mutual fund or an ETF, what’s most important is what’s held inside that fund. Think of an ETF as a basket that holds an array of securities, like stocks or bonds.

Most ETFs will hold just one type of security — only stocks or only bonds, for example. A bond ETF could be broad, or it could contain a narrower sliver of the bond market, like corporate bonds, green bonds, or short-term treasury bonds.


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What Is a Bond?

Effectively, a bond is a loan to an organization: i.e. a company, government, or other entity. Investors loan the entity their money, and then the entity pays interest on the amount of that loan.

Bonds are quite different from stocks, which offer investors the opportunity to buy shares of ownership in a company or entity.

There are countless types of bonds. Treasuries are loans to the U.S. government. Municipal bonds are loans to a state or local government. Companies sometimes issue bonds in order to raise money. These entities are borrowing money from investors and issuing IOUs in the form of bonds.

How Bonds Work

When investors buy a bond, they are agreeing to the rate of interest and other terms set by the bond. Because bonds pay a fixed rate of interest, bonds are sometimes referred to as fixed-income investments.

Bonds typically make interest payments, sometimes referred to as coupon payments, twice annually.

Example of a Bond

Let’s say an investor buys a Coca-Cola bond for $10,000 that pays a 4% rate of interest over 20 years. The bond earns $400 every year, earning the investor a total of $8,000 over the 20-year period. At the end of the period, the $10,000 “principal” investment is returned. As long as the investor holds the bond for the full 20 years, there should be no surprises.

Because bonds pay a fixed rate of return, their earnings potential is largely predictable. But there is limited upside on what can be earned on a bond. For this reason, bonds are considered to be a safer, less volatile complement to stock holdings, which have a higher potential for returns over time.

Types of Bonds

Bonds are issued by different entities and are often categorized by the issuer. There are four categories of bonds available to investors.

Treasury bonds: Bonds issued by the U.S. government.

Municipal bonds: Bonds issued by local governments or government agencies.

Corporate bonds: Bonds issued by a public corporation.

Mortgage and asset-backed bonds: Bonds that pass through the interest paid on a bundle of debts, such as a bundle of mortgages, student loans, car loans, or other financial assets.

As one could imagine, there are many subtypes within these broad categories.

When it comes to risk, the bond market produces a wide range. Corporate, municipal, and asset-backed bonds are generally considered to be higher risk than treasury bonds.

Whereas a business or even a municipal government could potentially “default” on a loan, it is highly unlikely that the U.S. government would go bankrupt. (As yet, the U.S. government has never defaulted on a treasury bond.)

Because they are considered low risk, U.S. treasury bonds typically pay less interest than the other bond types. This is an important trade-off to understand. Higher-risk investments should pay a higher rate of interest in order to compensate the investor for taking on that additional risk.

This is why it is possible to see bonds with high rates of interest issued by unstable governments or by highly speculative companies. These are often referred to simply as high-yield bonds or junk bonds.

Bonds can also vary by their maturity dates. It is possible to purchase bonds with a wide range of timelines, ranging from the very short (a few days) to the very long (30 years). Although it depends on the current state of interest rates, long-term bonds tend to pay more than short-term bonds. This should make intuitive sense; investors want to be compensated for locking their money up for longer periods.

Benefits of Bond ETFs

While bonds offer certain benefits to investors, including relatively low risk and predictable income, these instruments are complex. Owning and managing a portfolio of bonds requires experience and sophistication. This is where bond ETFs come in. In some ways, bond ETFs give retail investors easier access to the bond market.

Bond ETFs can be purchased in small dollar amounts.

For some bonds, the starting price is $1,000. This can be prohibitive for small investors who don’t have $1,000 to start building their bond portfolio, let alone a diversified one.

Generally, ETFs are sold by the share, and the cost of one share varies by ETF. Some trading platforms allow for the purchase of partial shares, which allows investors to get started with as little as $1.

They provide diversification.

It is possible to buy into a fund of hundreds or thousands of bonds using a bond ETF. This type of portfolio diversification would be otherwise impossible to achieve for small investors trying to build a bond portfolio on their own. ETFs make diversification a possibility, even at very small dollar amounts.

They are low cost.

ETFs, by their nature, are low cost. Because they are typically passive funds by style, the management fee embedded within the fund — called the expense ratio — is typically quite low. Compare this to an actively managed mutual fund of bonds, where the expense ratios can top 1%.

There’s another fee that investors will want to be aware of, called a trading cost or transaction fee. This is the cost of buying and selling ETFs (and stocks). These fees can be quite prohibitive for smaller investors. Luckily, there are ways to buy ETFs without paying any trading or transaction fees.

They are easy to buy and sell.

Individual bonds are not always easy to buy and sell. Said another way, they are not particularly liquid. Bonds do not trade on an open exchange, like stocks and ETFs. It is likely that an investor would need to involve a professional to broker the transaction.

ETFs, on the other hand, are very easy to sell. Most banks and trading platforms allow investors to do it themselves, online. This way, an investment can be sold quickly if needed.


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Downsides of Bond ETFs

Bond ETFs do have their downsides, though.

Bond ETFs reveal underlying price changes in the bonds, which some investors may find disconcerting. Because yes, it is possible for bonds, and a bond ETF, to lose value.

When holding an individual bond or a portfolio of bonds, an investor is not provided minute-by-minute updates of the market value of that investment. In this way, a bond is like a house. There is no ticker sitting above anyone’s house that tells them the value of that property at that very second.

This is not the case with a bond ETF, where price changes can be felt in near real time. It will be important that investors are prepared for this. It is generally not wise to make a decision about long-term investments based on recent price gyrations, not just with stocks but with bonds, too.

The Takeaway

The first step is to research bond ETFs, as there are many kinds. Bond ETFs can be broad and cover a wide sample of the bond market, or they can be narrower. For example, it is possible to buy a long-term treasury bond ETF or a bond ETF that only holds certain municipal bonds.

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Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

SOIN20151

Net income (NI), or net earnings, is the amount of money a company has left after subtracting operating expenses from revenue. Retained earnings goes a step further, subtracting dividend payouts to shareholders.

Companies have several different types of earnings, each of which provide different information about their revenues and insight into their financial health. On a company’s balance sheet — which is a key piece of information in evaluating a company’s stock value — it will report details about its expenses and earnings, including retained earnings and net income.

What Is Net Income?

Net income (NI) is an indication of how profitable a company is. It is a basic calculation showing the difference between its earnings and expenses, which can include labor, marketing, depreciation, interest, taxes, operational expenses, and the cost of making products.

How to Calculate Net Income

The net income formula below can be used to calculate the net income of a company:

Net Income = Revenue – Expenses

For example, if a company makes $50,000 in revenue during an accounting period and has $30,000 in expenses, their net income is $20,000.

Understanding Net Income

Net income is often referred to as the bottom line, since it appears on the bottom line of a company’s balance sheet and is the basic calculation of a company’s profit.

NI is used when calculating earnings per share, and is one of the key figures investors use when evaluating companies. When people talk about a company being in the red or in the black, they are referring to whether the company has a positive or negative net income.

It’s important to note that net income can be manipulated through the hiding of expenses and other means. It can be hard to figure out if this is happening, but investors might want to be wary of this and look into what numbers are being used in the net income calculation, and a good time to do so may be around a company’s earnings call.


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What Are Retained Earnings?

Retained earnings (RE) may also be referred to as unappropriated profit, uncovered loss, member capital, earnings surplus, or accumulated earnings.

Profitable companies try to strike a balance between reinvesting in their business and paying out dividends to please shareholders. After a company completes dividend payouts, they retain the amount of earnings that are left, and may decide to reinvest them into the business to continue to grow, pay off loans, or pay additional dividends.

It’s useful to understand RE when looking into companies to invest in, because they show whether a company is profitable or if all of their earnings are going towards dividends. If a company’s retained earnings are positive, this means they have money available to invest and put towards growth.

On the other hand, if a company has negative retained earnings, it means they are in debt, which is generally not a good sign.

How to Calculate Retained Earnings

Use the following formula to calculate the retained earnings of a company:

Retained earnings = Beginning retained earnings + Net income or loss – Dividends paid (cash and stock)

All of this information is available on a company’s balance sheet. In order to find beginning retained earnings one will need to look at the previous period’s balance sheet.

For example, if a company starts with $8,000 in retained earnings from the previous accounting period, these are the beginning retained earnings for the calculation. If the company makes $5,000 in net income and pays out $2,000 in dividends to shareholders, the calculation would be:

$8,000 + $5,000 – $2,000 = $11,000 in retained earnings for this accounting period. Since retained earnings carry over into each new accounting period, profitable companies generally have increasing retained earnings over time, unless they decide to spend them.

Understanding Retained Earnings

The calculated retained earnings show a company’s profit after they have paid out dividends to shareholders. If the calculation shows positive retained earnings, this means the company was profitable during the specified period of time. If the retained earnings are negative, this means the company has more debt than earnings.

Companies can use this figure to help decide how much to pay out in dividends and how much they have available to reinvest.

Although negative RI isn’t ideal, investors should consider the company’s individual circumstances when evaluating the results of the calculation. There are some instances in which negative retained earnings are fairly normal and not necessarily a reason to avoid investing.

How To Assess Retained Earnings

When assessing the retained earnings of a company, the following factors should be taken into account:

•   The company’s age. If a company is only a few years old, it may be normal for it to have low or even negative retained earnings, since it must make capital investments in order to build the business before it has made many sales. Older companies tend to have higher retained earnings. If a company has been around for many years and has low or negative retained earnings, this may indicate that the company is in financial trouble.

•   The company’s dividend policy. Some companies don’t pay out any dividends, while others regularly pay out high dividends. This will affect their retained earnings. In general, publicly-held companies tend to pay out more dividends than privately-held companies.

•   The period of time used in the calculation. Some companies are more profitable at certain times of year, such as retail businesses. If one looks at retained earnings during the holiday season or other popular times for retail, the company may save up their profits from those times in order to get through slower times. For this reason, the same company might show different retained earnings depending on what time period is used in the calculation.

•   The company’s profitability. More profitable companies tend to have higher retained earnings.

What’s the Difference Between Retained Earnings and Net Income?

Although retained earnings and net income are related, they are not the same.

Similarities

Both metrics help investors understand a company’s profitability, which is a chief similarity. They’re both calculated in similar ways, too, though obviously, calculating retained earnings requires some extra steps. Net income also has a direct impact on retained earnings.

Differences

There are differences to keep in mind. For one, you may not find retained earnings on a company’s income statement, and calculating retained earnings will differ from company to company as not all firms pay out the same dividends.

Note, too, that while net income helps with understanding profit, retained earnings help with understanding both profit and growth over time.

Example of Retained Earnings vs Net Income Differences

At times, a company may have negative retained earnings but positive net income — providing a good example of the difference between the two. This is what is known as an accumulated deficit. Or the opposite may occur. For example, if a company earned $60,000 in revenue and they have $40,000 in expenses, their net income is $20,000. If they then pay out $10,000 in dividends to shareholders, the retained earnings calculation would be:

$0 + $20,000 – $10,000 = $10,000 in retained earnings

If a company has a healthy net income and retained earnings, this may be a good time for them to reinvest some of their money into growing the business. In some cases, retained earnings and net income may be the same — as when a company doesn’t pay out dividends and has no retained earnings carried over from the previous period.


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Why Do Retained Earnings and Net Income Matter?

Investors are often interested in retained earnings and net income because they help show the long-term financial health of a company. Figures such as revenue and expenses vary with each accounting period, and they don’t give as accurate a picture of debt and opportunity for growth.

Understanding how much profit a company really has after dividend payouts and expenses can better help investors assess the risk and opportunity involved with investing in a company. Since RI carry over into each new accounting period, they show how much a company has saved, earned, and spent over time. (Another calculation used for evaluating a company’s profitability and debt is the debt-to-equity ratio, which is a measure of how much debt it takes for a company to run its business.)

Retained earnings are also useful for companies to help determine how to spend their money. If retained earnings and/or net income are low, it might be best for the company to save their money rather than reinvesting it or paying out dividends. If the numbers are high, they can consider spending it.

The Takeaway

Net income and retained earnings are two useful calculations that can help investors assess a company’s health, and that can help a company decide what to do with their earnings. They’re a key part of a company’s overall financial picture.

The big difference between the two figures is that while net income looks at revenue minus operating expenses, retained earnings further deducts dividend payouts from NI. Both can help form an overall view of the profitability and risk of a company.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

FAQ

Should retained earnings be higher than net income?

No, because retained earnings are derived from net income. Net income is a larger number, and retained earnings are calculated from net income.

Does retained earnings mean net income?

No, the two are similar metrics, but not the same. Net income is a company’s revenue minus expenses, and retained earnings incorporate expenses and dividends paid out.

How does net income flow to retained earnings?

Broadly speaking, retained earnings are the remainder of net income after the amount of dividends paid out to shareholders has been factored into the equation.

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