Not all fixed-income exchange traded funds (ETFs) are alike, and this simple fact is more important than ever as the economic recovery raises the likelihood that the Federal Reserve will raise interest rates.
As with other asset classes, the elements of the fixed-income space don’t react the same way to varying market conditions. For example, what makes corporate debt favorable isn’t necessarily what makes Treasuries favorable, too. That’s why they need to be considered and viewed on their own merits.
Muni Bonds
Muni bonds got a lot of headlines toward the end of 2010, and not all of them were favorable. This could well continue to be the case in 2011 as the most troubled states work to get their balance sheets in working order again.
The municipal bond market was whacked hard in a sell-off that sent them tumbling below their 200-day moving averages. PIMCO’s Bill Gross recommends avoiding places with big budget shortfalls, such as Illinois, and looking at beaten down areas such as California or New York City. Places such as those have the most potential to treat investors well later as they recover.
Although munis are a notch lower than Treasuries in terms of safety, large state and local deficit are the biggest risk in muni bonds. If a state or city goes bankrupt, though, the federal government could potentially bail them out and the bonds would still make quarterly dividend payouts. Of course, there are no guarantees, so it’s important to always bear this risk in mind.
Additionally, the shift of power in Congress to Republicans is also having an effect on the muni bond market. The extension of Bush-era taxes makes munis less desirable as a tax-haven asset.
Muni ETFs run the gamut, from broad funds to state funds, including iShares S&P California (NYSEArca: CMF), PIMCO Intermediate Municipal Bond Strategy (NYSEArca: MUNI) and Grail McDonnell Intermediate Municipal Bond (NYSEArca: GMMB).
Treasuries
Meanwhile, the uptick in interest rates and decrease in price has bond investors pulling out of Treasuries at a rapid clip. However, the latest sell-off may also be a result of end of the year portfolio balancing and profit-taking.
Treasuries are primarily in focus these days because the Fed is widely expected to raise rates at some point this year. Investors who sought safety and yields in long-term Treasury bonds may be at risk of losing their principal when this happens.
As a result of this concern, Americans were leaving bond mutual funds at the fastest rate in more than two years toward the end of 2010. As the prospect of cheap credit is dwindling, the rise in interest rates risks a standstill in lending across the board.
Also denting the appeal of Treauries these days are the passage of new tax deals, which will increase government debt over the next two years, as well as Moody’s threat to reduce the U.S. government’s debt rating as a result.
Treasury bond ETFs run all over the map, from actively managed funds to short-term to long-term and more. Among the largest Treasury ETFs are iShares Baclays 1-3 Year Treasury (NYSEArca: SHY), iShares Baclays 20 Year Treasury Bond (NYSEArca: TLT), Vanguard Extended Duration Treasury (NYSEArca: EDV) and PIMCO 1-3 Year U.S. Treasury (NYSEArca: TUZ).
Corporate Bonds
Corporate bonds were favorites with investors last year, and this year looks like it might be even better. Investors are demanding 1.66% more yield to hold U.S. investment-grade company debt instead of Treasuries, compared with an average 1.69% spread worldwide. The increasing spread yields of corporate bonds over Treasurys reflect investors’ growing confidence in the economic recovery.
Investors willing to accept slightly greater risk have been pouring into corporate bond ETFs in search of higher yields and a chance to get on the ground floor of a Corporate America recovery.