Breaking Down The Bond ETF

10/19/2015


Investors tend to long for the relative safety of bonds when stocks post big declines.

But potential Federal Reserve interest-rate hikes worry bond investors at a time when many have piled into exchange-traded funds (ETFs). There are now 231 bond ETFs, up from 75 at the start of 2010. Some worry that bond ETFs, which have seen assets jump 13% this year, haven't been sufficiently tested by a down market.

Many bond funds have grown unwieldy, making it harder to trade the underlying securities. In addition, low interest rates have compelled some funds to hold riskier and illiquid bonds to help boost income. Some investors fear that if rates rise, bond ETF losses will trigger widespread selling, prompting funds to unload holdings and intensifying selling pressure across the bond market.

SIZING UP BOND FUNDS
Like mutual funds, exchange-traded funds (ETFs) hold a bundle of bonds. While investors have flocked to ETFs in recent years, traditional bond mutual funds still rule the roost. All numbers except fund counts are averages.
------- Exchange-Traded Funds -------
------------- Mutual Funds -------------
No. Of
Funds
Yield
(%)
YTD
Return
(%)
Expense
Ratio
(%)
No. Of
Funds
Yield
(%)
YTD
Return
(%)
Expense
Ratio
(%)
Corporate
39
2.8
0.7
0.10
164
3.3
(0.1)
0.73
High yield
21
5.2
(0.2)
0.46
691
5.6
(0.6)
1.05
Inflation protected
12
0.3
(0.3)
0.16
217
1.1
(0.9)
0.78
Intermediate
government
8
1.6
2.1
0.15
265
1.9
1.2
0.91
Intermediate
municipal
10
2.1
1.7
0.28
275
2.4
1.3
0.83
Intermediate
term
19
2.5
1.4
0.25
965
2.5
0.7
0.84
Long-term
government
8
2.5
0.2
0.15
33
2.4
0.6
0.76
Short term
17
1.3
1.3
0.24
485
1.6
0.8
0.82
Short-term
government
9
0.5
0.7
0.13
110
1.3
0.8
0.61
Ultrashort
12
0.6
0.3
0.24
145
0.8
0.3
0.56
World
26
1.9
(3.2)
0.48
341
2.9
(2.4)
1.01

High-profile investors Carl Icahn and Howard Marks have warned that underlying assets in some ETFs include riskier and rarely traded bonds that may not find a ready buyer in a panicked market. Moreover, ETFs tend to be widely held by individual investors, who have a reputation for bailing out of volatile markets, potentially magnifying any sell-off.

But BlackRock ($322; BLK) CEO Larry Fink counters that argument by noting the difference between ETFs and traditional mutual funds. When investors redeem an open-end mutual fund, the fund often must sell securities to generate cash to return to the seller. In contrast, ETFs typically need not sell bonds in their portfolio to meet redemptions. More than 80% of ETF trades occur without an actual bond changing hands, according to ETF giant BlackRock, the issuer of iShares. Fink adds that bond ETFs have been shown to enjoy more liquidity than their underlying assets in volatile markets.

Many bond ETFs invest in thinly traded securities, which can impact trading liquidity and pricing. ETFs have two key numbers — net asset value (NAV), or underlying value of the securities in a portfolio, and market value, or price at which investors buy and sell shares.

Bond ETFs don't always trade at their NAV, partly because holdings can be difficult to trade, and because they tend to react slowly to pricing information. However, as the table below shows, most funds usually trade at a fairly small premium or discount to NAV.

Do your homework

While not foolproof, most U.S. bond funds offer stability, as well as a means of preserving wealth — appealing traits when the stock market turns frothy. Our Recommended Growth Portfolio is 17% invested in bonds, versus 25% for the Conservative Portfolio. Of course, bonds come with their own risks, so be mindful of these three when evaluating any fund:

Interest-rate risk. With the Federal Reserve signaling an eventual rate increase, investors need to consider that bond prices tend to move in the opposite direction as interest rates. An uptick in rates could cause bond funds to decline in value.

A bond's interest-rate risk increases with time to maturity — long-term bonds are more sensitive than short-term bonds to changes in interest rates. A fund's duration provides a decent gauge of how the share price will react to a change in interest rates. For example, a fund with an average duration of five years will see its share price fall about 5% in response to a 1% increase in interest rates.

The Forecasts recommends that subscribers invest the bulk of their bond portfolios in short- and intermediate-term bonds with durations of up to seven years.

Reinvestment risk. Though rising rates typically weigh on bond returns, the relationship does yield some good news — the potential for higher income and improved returns over the long haul. Reinvestment risk refers to the risk you will reinvest your money or income distributions at lower interest rates. But when rates are on the rise, newly issued bonds come with a higher payout, increasing the income investors receive, assuming they reinvest income or steadily invest more money.

Despite their lower yields, investors should hold some short-term bond funds, which generally replace bond holdings more frequently and as a result see their income stream increase more quickly if rates trend higher.

Credit risk. The risk that a company might not pay the interest or principal on its bond is credit risk. Standard & Poor's provides ratings that help gauge a company's creditworthiness, with high-quality (investment-grade) bonds rated AAA through BBB. High-yield bonds, commonly called junk bonds, earn ratings of BB or lower and are considered aggressive investments.

Investors should focus mostly on funds with investment-grade bonds. However, high-yield bonds, which have come under pressure because of their limited trading liquidity, still have a place in many accounts and represent about 5% to 6% of our recommended fund portfolios.

Recommendations

If you wish to build a bond portfolio using traditional mutual funds, we suggest those listed among the Forecasts fund recommendations. Baird Core Plus Bond ($11; BCOSX) is a solid core holding and a member of both recommended portfolios. The fund, yielding 2.4%, invests mostly in corporate and mortgage-backed securities and has a duration of 5.5 years.

If you wish to invest in ETFs, consider the table below of 20 standouts in 10 categories. We selected funds with solid track records and reasonable expense ratios relative to category averages. Nearly all earn strong scores in our rating system, which covers 98 bond ETFs.

ETF investors should consider Vanguard Short-Term Corporate ($80; VCSH), an excellent all-weather holding. We use this fund, which yields 1.9%, for the cash portion of our buy lists. The ETF, which has a duration of 2.8 years and charges a modest 0.12% expense ratio, boosts a fund score of 99.


Truly cautious investors might prefer Vanguard-Term Short-Term Government ($61; VGSH).  The ETF, which yields 0.6%, has a duration of only 1.8 years and invests only in AAA-rated bonds.

20 TOP PICKS AMONG BOND EXCHANGE-TRADED FUNDS
Portfolio
--- Composition ---
Average
Premium
Or
Discount
To NAV
(%)
-- Total Return --
Fund (Price; Ticker)
Yield
(%)
Duration
(Years)
Average
Credit
Quality
Govern-
ment
(%)
Corporate
(%)
Expense
Ratio
(%)
Year-
To-Date
(%)
3 Yrs.
(Ann.)
(%)
Fund
Score
Corporate
SPDR Barclays Intermediate
Term ($34; ITR)
2.6
4.4
A
0
99
0.24
0.12
1.5
1.9
93
Vanguard Intermediate-Term
($86; VCIT)
3.3
6.5
BBB
1
99
0.19
0.12
1.6
2.5
83
High Yield
iShares iBoxx $ High Yield
Corporate ($85; HYG)
5.7
4.1
B
1
99
0.16
0.50
(1.6)
2.9
49
SPDR Barclays High Yield ($36; JNK)
6.3
4.3
B
1
99
0.17
0.40
(2.0)
2.4
34
Inflation Protected
PIMCO Broad U.S. TIPS ($56; TIPZ)
0.6
8.4
AAA
98
0
0.05
0.20
(0.6)
(2.0)
95
Schwab U.S. TIPS ($54; SCHP)
0.1
7.8
AAA
100
0
0.03
0.07
(0.3)
(1.8)
98
Intermediate-Term Government
Schwab Inter.-Term U.S.
Treasury ($55; SCHR)
1.5
5.2
AAA
100
0
0.03
0.09
2.9
1.5
94
Vanguard Intermediate-Term
Gov't ($66; VGIT)
1.6
5.3
AAA
98
0
0.09
0.12
2.6
1.4
89
Intermediate Term (General)
Vanguard Intermediate-Term
($85; BIV)
2.7
6.5
A
58
40
0.13
0.10
2.5
2.0
83
Vanguard Total Bond Market
($82; BND)
2.4
5.7
AA
46
25
0.03
0.07
1.4
1.6
74
Long-Term Government
SPDR Barclays Long Term
Treasury ($72; TLO)
2.6
17.4
AAA
100
0
(0.04)
0.10
0.0
2.7
100
Vanguard Long-Term Gov't
($77; VGLT)
2.7
16.8
AAA
98
0
0.06
0.12
0.1
2.7
94
Intermediate-Term Municipal (Tax Free)
iShares National AMT-Free Muni
($110; MUB)
2.6
7.0
AA
0
0
0.13
0.25
1.1
2.1
66
Market Vectors Intermediate Muni
($24; ITM)
2.4
6.5
AA
0
0
0.14
0.24
1.7
2.4
74
Short-Term Government
Schwab Short-Term U.S. Treasury
($51; SCHO)
0.6
1.9
AA
100
0
0.01
0.08
0.9
0.6
95
Vanguard Short-Term Gov't
($61; VGSH)
0.6
1.9
AAA
99
0
0.03
0.12
0.9
0.6
97
Short Term (General)
Vanguard Short-Term ($81; BSV)
1.3
2.7
AA
71
26
0.03
0.10
1.6
1.1
80
Vanguard Short-Term Corporate
($80; VCSH)
1.9
2.8
A
0
99
0.10
0.12
1.5
1.6
99
Ultrashort
Guggenheim Enhanced Short
Duration ($50; GSY)
1.4
0.2
NA
1
15
0.01
0.30
1.0
1.2
100
iShares Floating Rate ($50; FLOT)
0.5
0.2
A
7
63
0.00
0.20
0.1
0.5
NA

 


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RECOMMENDED MUTUAL FUNDS
To mimic our Recommended Growth and Conservative portfolios, purchase the funds listed below in the proportion suggested by the target weights. If you just want our favorite picks among bond funds, consider the funds listed in bold. Note that full-page reports are available on all 20 funds, at www.DowTheory.com/Go/Funds.
Portfolio
-- Target Weight --
Total Return & Category Rank *
Fund (Price; Ticker)
Fund Category
Conser-
vative
(%)
Growth
(%)
YTD
(%)
3-Year Ann.
(%)
Exp.
Ratio
Rating
Phone
Number
(800)
Artisan International
($28; ARTIX)
Foreign large-co.
growth
9
9
(6.5)
E
7.0
C
1.17
46
344-1770
Baird Core Plus Bond
($11; BCOSX)
Intermediate-
term bonds
9
4
1.2
B
2.1
B
0.55
89
444-9102
Dreyfus MidCap Index
($37; PESPX)
Midcap blend
0
0
(0.9)
B
14.7
B
0.50
54
373-9387
Dreyfus Small Cap Stock
Index ($29; DISSX)
Small-company
blend
0
0
(1.3)
B
15.2
B
0.50
86
373-9387
Homestead Small Company
Stock ($38; HSCSX)
Small-company
value
5
6
(2.3)
C
15.7
A
0.89
84
258-3030