A Pro’s Guide to Fixed Income Investing: Funds, ETFs or SMAs?

With equity market volatility on the rise, cryptocurrencies collapsing, heightened concerns around the effects of artificial intelligence, and other geopolitical issues weighing on investment portfolio returns, where can investors turn to experience less drama and still receive an attractive return? Fixed income and the bond market.

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Why Is Now a Good Time for Fixed Income?

In the past few years, bonds have been the most under-appreciated asset class, the Rodney Dangerfield of investments (Gen Zers look him up), and rightfully so. Beginning with the aftermath of the Great Financial Crisis and ending with the Covid crisis, bond market returns were suppressed. For much of that time, global central banks held interest rates to zero and, in some countries, below zero. As a result, fixed-income returns for the past few years have been less than exciting.

But since the Federal Reserve and other central banks stopped hiking interest rates, the returns on bonds have been exciting, at least for us fixed-income nerds. The Bloomberg Aggregate Bond Index total return for 2025 was up 7.30%, the best year for that index since 2020. Additionally, the Bloomberg Municipal Bond Index was up 4.25% for 2025.

The primary driver of last year’s attractive fixed-income returns was higher yields, resulting from Fed interest rate hikes in 2022 and 2023. Bond market returns are calculated using both income and price returns. When bond yields are high, they provide strong tailwinds for future returns and a cushion to offset negative price movements.

We can estimate how high interest rates would have to increase before the expected total return of the bond would be negative over a one-year time horizon. The current breakeven yield hurdles for both the Bloomberg Aggregate Bond Index and the Bloomberg Municipal Bond Index are near the highs of the last 16 years. Yields in the taxable bond market would have to increase by an estimated 0.71 percent—and 0.50 percent for the tax-exempt market—over the next 12 months before the total return would be zero. Not a bad cushion.

Those higher yields, which drove the returns in 2025, are still available as we start 2026. Both real yields and nominal yields for bonds are near the highs of the last five years.

Real yields are simply the yield of a bond after adjusting for inflation. In previous years, fixed income offered little positive real yields, and at times, even less than zero. The current positive rate environment is an opportunity worth capturing.

Why Bonds Bring Stability to a Diversified Portfolio

In addition to providing attractive potential returns, bonds offer more stability than other asset classes, excluding cash of course. In its simplest terms, a bond is a series of cash flows. In the example of a US Treasury bond, the prompt payment of coupons and par value at maturity is guaranteed by the full faith and credit of the US government. For the average corporate and municipal bond, the payments are not guaranteed by the US government but are an obligation of the underlying issuer.

This stability is evident by looking at bond market returns over time. Over the last 50 years, the Bloomberg Aggregate Bond Index has posted only five calendar years of negative total returns, and the Bloomberg Municipal Bond Index has posted only seven negative years since its inception.

In general, a default or other impairment is the only event that can change the expected cash flow. The default risk of a bond can be mitigated through proper credit research and diversification. If such an outcome does occur, senior debt typically has priority over equity when assets are distributed.

While the price of a bond changes with market fluctuations, the cash flow the investor receives will not, unless you sell the bond before maturity. Even though other investors may pay more or less for the exact same bond, your cash flow is unaffected. This stability cannot be found in other riskier financial instruments.

Because of their inherent stability, bonds can sometimes function as a hedge against riskier asset classes, such as stocks, crypto, currencies, commodities, and other investments. When risk assets experience sudden declines in prices coupled with an increase in market volatility, investors typically gravitate towards the stability of bonds—particularly US Treasury bonds because of their guarantee. This results in a natural hedge because bond prices tend to rally when risk assets sell off.

However, when interest rates move significantly higher over an extended period, bond prices will fall as well. This was the case in 2022, when record-high inflation forced global central banks to increase policy rates. Higher interest rates weighed on both bond and risk assets. Bond price returns were negative but less so than other investment classes.

I do not believe we are in such an environment right now, and recent market volatility has shown the hedge is alive and well.

How to Invest in Fixed Income

The first step to investing in fixed income is to identify the type of account in which the bonds will be held. This will help to decide whether tax-exempt securities (like municipal bonds) or taxable bonds (like Treasuries and corporate bonds) are appropriate.

Most importantly, will the portfolio be subject to income and/or capital gains taxation by federal, state and/or local authorities? Or will the account be free from paying any capital gains and income taxes?

Accounts such as IRAs, 401(k)s, 529s, and other retirement accounts are generally allowed to grow tax free. The available universe of bonds for these types of accounts can include government, corporate, asset-backed, and other taxable bonds, but should avoid tax-exempt municipal bonds.

For accounts that are taxed, investors should include all bond types.

For those in a high tax bracket, tax-exempt municipal bonds should be the focus, but not exclusively. There are times when market conditions fluctuate and it is more beneficial for an investor in a high tax bracket to buy a taxable bond and pay the income tax, than it is to buy a comparable tax-exempt municipal bond. More on that later.

What Is the Best Way to Add Bonds to a Portfolio?

Once the tax nature of the account has been decided, there are numerous options to access the bond market.

Do-It-Yourself

For the do-it-yourself investor, many types of bonds can be bought online through your broker, or Treasury bonds can be bought directly from the US Treasury at treasurydirect.com.

Professional Management

For those not comfortable with the DIY approach, those looking for professional management, there are different types of investment vehicles available. The options are a separately managed account (SMA), a bond mutual fund, or a bond ETF. In addition to this decision, investors should also determine whether they want an active or passive fixed-income manager. Let’s walk through the pros and cons.

Selection: For mutual funds and ETFs, the investor can choose among diverse options, which can be daunting for a beginner. Most online brokers can help with this decision, however, it is extremely important that investors do their own homework—more on that after the basics are established. For a separately managed account, a professional manager will create a suitable fixed-income portfolio that fits the investor’s specific situation, but the manager may require a minimum investment.

Fees: The fees for mutual funds and ETFs are generally much lower than the SMA option. For those with complicated investments, the higher fee may be a better choice.

Liquidity: The liquidity, which is how quickly an investor can withdraw money from an account, is highest for the ETF option because they trade like stocks throughout the day. A mutual fund is priced at the end of each trading day, and the proceeds are available the next day. For an SMA, liquidity depends on the underlying assets—it can take a day or two at best, and even longer, for some types of bonds to sell.

Transparency: ETFs have the most transparency as their holdings are disclosed daily. Mutual funds have less transparency, although in response to increasing ETF popularity, this has been improving. For SMA investors, a monthly statement should always be available.

Diversification: Diversification in holdings is generally greater in larger ETFs and mutual funds than SMAs. For index-based mutual funds and ETFs, the diversification in assets will mirror that of the index. The larger the diversity of the index, the more diverse the fund, and vice versa.

I should also note that there has been an increasing trend over the last few years of mutual funds converting to ETFs. Investors should not be surprised if such a conversion were to happen to their bond mutual fund investment.

Active or Passive Fixed-Income Management?

After the type of account and the investment vehicle has been determined, the next step is to decide whether active or passive management makes sense.

Passive Fixed-Income Management

A passive bond strategy is a portfolio that seeks to duplicate the holdings of a specific index or strategy and will generally hold the bonds to maturity regardless of market fluctuations.

There are passive fixed-income ETFs and mutual funds now that are tied to a variety of fixed-income indexes. The passive ETFs universe has grown over the last few years, and in fact, the largest bond fund , be it ETF or mutual fund, is the Vanguard Total Bond Market ETF (ticker BND). According to Bloomberg, BND hasBND over $152 billion in assets and seeks to mirror the Bloomberg Aggregate Bond Index.

The key to selecting a suitable passive fund or ETF is to understand the underlying index —know your index! As an example, the Bloomberg Aggregate Index is the largest domestic bond index and is composed of 46% Treasury bonds, 4% government-related bonds, 24% corporate bonds and 26% securitized bonds, such as mortgage-backed securities, and has an average maturity of 8.1 years.

While a fund tied to this index may make sense for investors with a long time horizon and a very conservative risk profile, it may not be suitable for those investors with a short time horizon. A passive bond fund with an index that closely matches the investor’s time horizon, goals and risk profile would be a more suitable investment.

Another popular passive strategy is a bond ladder. A bond ladder is simply a portfolio with an even distribution of maturity. When a bond matures, the proceeds are reinvested into bonds at the long end of the maturity range. This strategy is available in SMA, mutual fund and ETF form. This may be suitable for those looking for a regular schedule of bond maturities, which can provide added certainty to investors.

Active Fixed-Income Management

An active bond strategy is where the portfolio manager tries to outperform an index or other benchmark by buying and selling bonds at their discretion.

Investors can choose from numerous active bond ETFs and mutual funds, as well as active SMA managers. Each of these options should have a stated benchmark, excluding some customized SMAs.

Similar to the passive investment selection process, the alignment of the benchmark to the investor’s goals and risk profile is essential. A review of the active manager’s track record versus the benchmark is also important.

How to Choose Between Active and Passive Fixed-Income Management

Choosing between passive or active management can be difficult. They both have their pros and cons. Investors should look for the following when deciding.

Has the active manager been able to consistently outperform its benchmark on an after-fee and after-tax basis? Passive management typically comes with a lower fee, however, if an active manager has consistently produced better returns on an after-fee basis, then the investor may be better off with an active manager.

Investors should also consider tax ramifications. An active manager will buy and sell bonds as a normal course of business. Selling bonds at a gain can cause a taxable event, the recognition of a capital gain. In general, portfolio managers try to avoid capital gains recognition, especially in municipal bond portfolios, but they can occur. It does no good for a municipal bond fund to outperform its index, only to give the investor a tax bill at the end of the year. (More to come later on tax-loss harvesting.) Check the fund’s history for capital gains distributions.

Are Passive Bond Funds Better Than Active Bond Funds?

A recent Morningstar report showed that over the last five years, 55.3% of active intermediate core bond managers were successful in outperforming similar passive funds, and over the past 10 years, 52% of corporate bond fund managers were successful. These results show that active bond managers may be worth the higher fee.

How to Measure Success in Fixed Income Investing

When choosing a bond investment, or any investment for that matter, the primary goal is to find the right investment vehicle, strategy, and then the proper fund or manager that aligns with your goals, objectives, and risk tolerances.

For fixed-income portfolios, short-term goals should be matched with shorter-maturity strategies and long-term goals with longer-term maturities . If safety of principal is a priority, then an investment-grade bond strategy instead of a high-yield strategy or other riskier bond sector may make sense. If you are in a low marginal tax bracket, then a portfolio of taxable bonds instead of tax-exempt municipal bonds could be a better choice.

Once implemented, success should not be measured exclusively on the lowest fee, or the best performance, or the most tax efficiency, or the least volatile. The proper way to measure success is based on both quantitative and qualitative criteria.

The best qualitative measure is one that measures performance on an after-fee, after-tax basis. Many bond investors forget the after-tax part. It does no good if the investment performance net of fees is impressive if the government will take the bulk of the performance away in taxes.

In qualitative terms, the question I like to ask is, “In looking at the performance of your portfolio, given the ups and downs in markets over the last years or months, do you stay up at night worrying about your investment?” If the answer is yes, then you may need to move to a less volatile strategy or engage a professional money manager to help.

How Does a Customized, Actively Managed SMA Work?

Full disclosure, I am an active fixed-income manager specializing in customized, separately managed portfolios. I do believe this type of approach has advantages over other options, though with exceptions.

For investors with enough assets, a customized bond portfolio is the ideal solution. This type of implementation is specifically designed to align the investment with their objectives and risk profile.

A customized bond portfolio offers flexibility to change strategies when and if the investor’s objectives or situation changes. A professional manager can do so with minimal impact on the portfolio and subsequent tax ramifications.

The customized SMA structure can also maximize tax efficiency. Loss recognition in taxable bond portfolios is a valuable tool to help reduce taxes. In its simplest form, this technique sells bonds to recognize a loss and then replaces them with other bonds that are different enough to satisfy the IRS rules but still provide comparable cash flows. The recognized tax loss can then be used to offset recognized gains, thereby reducing the investor’s tax liability. Mutual funds and ETFs cannot employ this technique as they cannot distribute recognized losses, only gains.

SMAs also allow for a larger universe of potential bond investments. A typical bond mutual fund or ETF may be limited by prospectus to certain bond classes. This limitation may hinder opportunities that could arise.

As an example, there are times when municipal bonds become quite expensive due to the changing supply demand dynamics. During such times, it may be more advantageous for a taxable investor to buy taxable bonds instead of tax-exempt municipal bonds. A municipal bond fund or ETF is generally not allowed to buy taxable bonds, with a few exceptions.

To maximize their after-tax return, a customized approach with knowledge of the investor’s specific marginal tax rate is needed. What makes sense to a Florida taxpayer may not make sense to a California taxpayer. Only a customized portfolio can maximize tax efficiency to this extent.

Who Should Consider a Customized SMA?

A customized SMA is not for everyone. For smaller-sized accounts and investors who are adamant about low fees, an SMA may not make sense. For those investors wanting to invest in illiquid and/or overly complex, higher-risk instruments—where diversification and specialized analysis is needed—a fund or ETF may be the answer.

The Bottom Line: Now Is the Time for Fixed Income or to Rethink Current Bond Portfolios

Bond yields are currently attractive, and expected returns are strong. Now is the time for novice bond investors to consider fixed income and for those already in bonds to rethink their current portfolio.

By Chris Gunster, CFA, Contributor