Why It’s Time to Approach Bond ETFs Differently

January 6th at 6:00am by Tom Lydon

Bond ETFsFor decades, the popular fixed-income investing adage held that you should allocate a certain percentage of your portfolio to bonds and increase that allocation as you age. But the times, they are a-changin’.

Jim Ross, president and senior managing director at State Street Global Advisors cautions, “Now is not the time to just buy some bonds and forget about it.” That approach could get you burned.

Ross instead urges investors to take a more active role in their fixed-income portfolio, especially as the threat of rising interest rates looms. That makes it more important than ever for investors to look at the bonds they hold and ensure that they’re diversified across the yield curve. It’s important to be nimble and reactive as interest rates rise and fall. [What the yield curve means for ETFs.]

As rates change, it affects bond exchange traded funds (ETFs) in different ways. A long-term bond fund will take a greater hit to its value when interest rates rise than a short-term bond fund. When interest rates fall, the reverse is true.

Just as you would take a diversified approach to the equity side of your portfolio – perhaps some allocation to emerging markets, some more to domestic stocks and so on – Ross urges investors to think of their fixed-income portfolio in the same way.

“If you look at where the inflows have been, it’s mostly core [bond] funds. Investors just go get the broadest thing out there,” Ross says. The trouble with that? “You’re taking on the risk of potential rate hikes.” [High-yield ETFs: Is the party over?]

You could also potentially be ignoring the bigger picture. When it comes to equities, investors often buy based on what they think will happen: small-cap may outperform large, or domestic stocks might outperform global ones.

“People need to look at bonds the same way.” Ross says. If you’re investing in a particular bond type because you have a specific view of the market, a broad fund won’t give you much of the exposure you’re seeking. [Benefits of international bonds.]

Ross is heartened by the increased allocation to fixed-income in many portfolios, up from 40% closer to 60%. But if bond funds represent that much of a chunk, he says, investors need to carefully consider what they should be buying.

If your view is that the U.S. dollar will continue to weaken, international Treasuries and both U.S. and non-U.S. Treasury Inflation-Protected Securities (TIPS) “make complete sense,” says Ross. [TIPS: Your questions answered.]

In the event of stagflation – little to no growth coupled with inflation – investors may head to the short end of the yield curve.

“The old buy-and-hold approach on the equity side didn’t necessarily work out in the last 10 years. Buy and hold on the fixed-income side may not necessarily help, either.”

Ross doesn’t feel this way simply because we’re in a low-rate environment, either. Taking a more active role in your fixed-income portfolio should be a long-term shift, he says. “You could make the case that it should have been there five years ago.” [How to research bond ETFs.]

The best yields right now, says Ross, are those coming from high-yield bond funds, such as the SPDR Barclays Capital High Yield Bond (NYSEArca: JNK), which is yielding 12%. iShares iBoxx $ High Yield Corporate Bond Fund (NYSEArca: HYG) is yielding 9.8%.

In a recent appearance on CNBC, Ross’s pick for the current environment is the SPDR Barclays Capital Short-Term Corporate Bond (NYSEArca: SCPB), which launched last month. It tracks the 1-3 year U.S. investment-grade corporate bond market.

Don’t be afraid to look abroad, either, says Ross. In fact, his feeling is that U.S. investors are under-allocated to international bonds for the same reasons they’re under-allocated in international equities. “Anytime you go outside the U.S., there’s more perceived risk.”

But international yields right now are a little better than those in the United States, meaning that they may be an opportunity for a yield pickup. An additional benefit of international fixed-income investing is that it’s a dollar play, as well. “If the dollar strengthens, you lose,” says Ross.

International fixed-income plays include the SPDR Barclays Capital International Treasury Bond (NYSEArca: BWX) and the SPDR DB International Government Inflation-Protected Bond (NYSEArca: WIP).

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.