When it comes to equities, you want to give your clients a basket that contains exposure to a well-rounded mix. You might have some health care sector exposure, a little bit of oil and a single-country fund.
Are you approaching bonds the same way? If not, you should be.
Not all bond types are created alike – some are more tax efficient, some do better in low-interest rate environments, others do better in improving economic times and so on.
Bond exchange traded funds (ETFs) make it easy to get this level of diversification, and your options range from the safer U.S. Treasuries to high-yield bonds, and they come in a range of maturities and ratings. Bond ETFs can be divided into four primary categories: U.S. government, municipal, corporate and international.
TIPS for Inflation
Another option you have in the bond space is TIPS: Treasury Inflation-Protected Securities, which are meant to be used in inflationary environments.
As consumer prices increase, the interest from bonds becomes worth increasingly less. When bond yields are high, this isn’t much of an issue, but right now bond yields are low. Inflation could sock investors once it kicks in. But that’s not all: when inflation kicks in, the government tends to raise short-term rates.
One option to hedge against inflation is through TIPS, which are bonds with built-in inflation protection.
TIPS are similar to regular Treasury bonds in that they have the same credit risk – effectively none – and they’re issued by the government. But the difference is how they pay the coupon. If you buy $100 at inception and the rate of inflation is currently 2% for 10 years (the date of maturity), the principal will grow 2% each year.
U.S. Government Bonds
U.S. government bonds, or Treasuries, are generally considered to be the safest investments around.
The argument for owning Treasury bonds is that the economic recovery may be slow going at best. But even in that environment, the protection may be short-lived. Investors have rushed to buy Treasury securities since late April, in the process driving market yields on the bonds sharply lower.
When interest rates rise, the prices on these bonds may fall, and investors still in them will lose principal if this happens.
Gone are the days of making easy money in the Treasuries market. The factors that fueled the bond boom are becoming unraveled: the inflation decline, and the sharp drop in market interest rates. Also, on a global scale, investors began fleeing to Treasury bonds as a safe haven when the market went bust.
Fiscal tightening makes it more likely that the Federal Reserve and the European Central Bank, among others, will keep short-term interest rates near rock-bottom a while. This is presenting a fertile environment for investors and providers to offer and seek out Treasury bond funds.
Still, if you are worried about interest rates, short-term bonds may a good choice since they are less influenced by changes in interest rates.
The only possible risk in the Treasuries market would be a colossal economic downturn or a large-scale war that would prevent the government from repaying short- or long-term debt obligations, so keep this in mind.
You can easily keep track of the performance of Treasury bonds by signing up for alerts, which will send you an email when a trading opportunity has been reached.
Municipal bonds, or “munis,” may provide tax-free returns and a steady stream of income. Cities, counties and states issue municipal bonds to fund projects such as schools, hospitals and airports. Many consider these to be the next safest category of investments behind Treasuries. Defaults have happened, but they’re rare.
Municipal bond ETFs hold a diverse collection of state and project development initiatives. The two major types of municipal bonds are revenue bonds and general obligation bonds. General obligation bonds are supported by taxes, whereas revenue bonds are supported by the income generated by projects funded. Both types are tax-exempt and relatively low risk.
Purchasing muni bond ETFs is not totally free of risk:
- Poor economic conditions and lower tax revenues could lead some states to default – risk is less severe for general obligation bonds and more severe for munis tied to private institutions.
- Increases in future inflation also translate to lower returns in bonds with more long-term maturity dates.
- An issuer may not meet all financial obligations. Credit ratings agencies will report the credit risk of an issuer.
- If one’s marginal income-tax rate reduces, it may be better to consider higher-yield bonds than holding onto municipals.
- As interest rates rise, newly issued bonds will pay higher yields than existing ones.
You can find a complete list of muni bond ETFs in our ETF Analyzer.
Corporate bond ETFs cover debt issued by publicly-traded firms. These ETFs hold a basket of investment-grade or below investment-grade “junk” bonds as defined by credit ratings agencies.
Overall, investment-grade corporate bonds have been a good place to hide and even profit. This is especially true right now, as market uncertainty has pushed Treasury yields down below 3%. Investors can find attractive yields in the corporate bond space.
Further strengthening the case: high-quality corporate debt has significantly outperformed equities in recent months, and corporate bonds are considered safer than common stocks since bondholders receive priority over stockholders in the event of bankruptcy.
One risk to be mindful of, however, is the influx of corporate bonds as corporations restructure and renew debt. This could lead to an oversupply that would result in prices stagnating or falling.
There’s a caveat, though: with high yields comes high risk. Junk bonds are more likely to default and their prices are closely tied to the corporations that issue them. Picking out individual junk bonds is more like speculation. That’s why investing in junk bond ETFs helps mitigate risk by holding a large pool of junk bonds within the fund’s portfolio.
International Sovereign Debt
International sovereign debt ETFs can be beneficial if you want greater diversification. International bond ETFs come in both developed market and emerging market flavors. Sovereign debt is debt issued by a national government.
With all the financial problems hovering over the eurozone, emerging market debt may look like a better alternative due to their rapid economic growth. Furthermore, emerging market sovereign debt also helps diversify a portfolio.
Still, when considering an international bond ETF in either developed or emerging markets, it is important to look at country risk, or the economic, political and business risks that are unique to a specific country or region.
Financially stronger economies will obviously provide more reliable investments than weaker ones. Additionally, political decisions may result in unanticipated losses if the political climate turns adverse to foreign investors. It is also important to factor in the credit ratings of the issuing countries.
Emerging markets offer a mix of sovereign, municipal, corporate and structured debt in either local currency issues or issues denominated in U.S. dollars or another developed currency. However, emerging markets are also riskier than developed markets due to greater political uncertainty and volatile boom and bust economic cycles.
With your membership comes the ability to create an unlimited number of model portfolios or use one of our own fixed-income model portfolios:
If you opt to strike out on your own with a fixed-income portfolio, remember that you can set up alerts for trading signals as well as rebalancing reminders. On top of that, you can easily track the performance of your model portfolio on the Dashboard!
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.