Bonding With ETFs

Attention bond investors: Exchange-traded funds might have a place in your portfolio. Here's why.

BACK IN THE go-go 1990s, bonds were for bores. Stocks were where the real action was.

All too often, fixed-income securities have been dismissed as fuddy-duddy counterparts to their hip 'n happening equity cousins. Of course, when the last bull market stumbled and fell, bonds were back in vogue. Suddenly, the safety offered by fixed-income investments seemed downright sexy compared with equities' massive losses.

Market-rattling events tend to yank investors back to the tried-and-true tenants of asset allocation. But portfolio vigilance is equally important after a year like 2003, when equities soared.

Historically, individual bonds and bond mutual funds have been the fixed-income instruments of choice for most investors. While buying individual bonds is the most efficient way to achieve long-term investing goals, it can involve a larger capital outlay than many investors can afford. Bond funds offer a cheap alternative. But, as with any actively managed investment product, there are fees that can eat into profits.

Now there's a third option to consider: fixed-income exchange-traded funds. These are portfolios of bonds that, like other ETFs, can be bought and sold like stocks. They're a low-cost, transparent and tax-efficient way to track a range of bond indexes. Like bond funds, fixed-income ETFs don't mature, but instead maintain a portfolio that reflects the underlying bond index's target maturity. And like stocks and unlike traditional mutual funds, fixed-income ETFs can be short-sold, traded on margin and hedged with options — offering individuals some fairly exotic investing possibilities. Of course, ETF trades require a broker, just as stock trades do, so there are transaction costs to consider.

Barclays, which launched the first bond ETF in July 2002, is the sole U.S. provider of such products, with six iShares funds on the market (see table). Three track Lehman Brothers' bond indexes of varying maturities, one follows Lehman's corporate bond index and another tracks the broad U.S. investment-grade bond market as represented by Lehman's U.S. Aggregate Index. There's also an iShares ETF that tracks Treasury inflation-protected securities, or TIPS — fixed-income instruments that are adjusted for inflation.

While there's still less than $6 billion in fixed-income ETF assets — a mere fraction of the iShares fund family's roughly $75 billion and the overall ETF market's nearly $160 billion — these products are gaining popularity. Since there's little performance difference between large, liquid government bond funds, managed accounts increasingly are turning to less costly fixed-income ETFs, says David Haywood, director of alternative-investments research at Boston-based Financial Research Corp. Why? They're easier to use and more cost efficient than laddering (buying individual bonds of varying maturities), according to Haywood. And with investors' use of managed accounts expected to increase, so should the use of bond ETFs.