Attention bond investors: Exchange-traded funds might have a place in your portfolio. Here's why.
ASIDE FROM EASE of use and cost efficiencies, bond ETFs are a great way to diversify risk.
Owning an ETF that tracks the corporate bond index with 100 bonds is a less risky proposition than placing a bet on one or two corporate bonds, says Lee Kranefuss, chief executive of Barclays Global Investors' Intermediary Business. Recent scandals have shown all too well that even investment-grade bonds can quickly turn sour. Moreover, fixed-income ETFs involve a certain level of professional management in monitoring bonds' credit quality and ensuring that target maturities are maintained. And there's transparency in pricing, which is important for any trade.
Of course, any discussion of bonds must include the nagging matter of interest rates and when the Federal Reserve will act to raise them. But a looming rate-hike issue shouldn't deter folks from dipping their toes into the bond market, say experts. It just makes certain bonds more attractive than others.
In a rising interest-rate environment, bonds of shorter durations are generally the vehicle of choice. The idea is to hold short-maturity bonds so that when interest rates rise, new bonds with higher coupons can be purchased. If investors are locked into longer-maturity bonds, they'll be at a disadvantage when rates rise and bonds with higher coupons are offered: Not only will their money be earning less than it could, but buyers for bonds offering lesser coupons are often scarce. So experts say the name of the game now is to go short-duration.
Luckily, purchasing shorter-maturity bonds in a low-cost way plays perfectly into ETFs' strengths, says Michael Kitces, director of financial planning at Columbia, Md.-based Pinnacle Advisory Group. Generally speaking, the shorter the bond duration, the more efficient the market tends to be, explains Kitces. So using an actively managed short-term bond fund is less necessary than, say, a managed fund for municipals or high-yield bonds, which have less efficient markets. "I think there's a lot to be said about fixed-income ETFs in this market," says Kitces.
If you agree with the prevailing view that the next move for interest rates is higher, purchasing shorter-duration fixed-income ETFs can provide bond exposure and minimize interest-rate risk. An even more aggressive play is to short-sell a longer-maturity ETF, such as iShares Lehman 20+ Year Treasury Bond Fund (TLT). Typically, the longer the bond duration, the greater the price movement, explains Kitces. So shorting longer-duration bonds in a rising interest-rate environment can translate into greater gains for investors. But this carries more risk. "As much as people like to talk about rising rates as a foregone conclusion, it's really not," says Kitces.
Increasingly, fixed-income ETFs also are being used as alternatives to money markets, experts say. With money-market funds offering paltry yields, investors can squeeze out better returns by assuming a bit more risk with shorter-duration fixed-income ETFs. Consider that the iShares Lehman 1-3 Year Treasury Bond Fund (SHY) carries a yield of 1.75%, far surpassing the average taxable money-market yield of 0.51%.
While bonds may not seem sexy, fixed-income ETFs can add just the right amount of spice to a portfolio.
Boring? We beg to differ.