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.
Market participants expect more high-grade issues will be sold as earnings pick up and blackout periods commence. Researchers note that investors are likely feeling more comfortable with corporate debt in light of the strong earnings season just witnessed.
If you’re still concerned about default risk, you may be more comfortable withiSharesiBoxx $ Investment Grade Corporate Bond (NYSEArca: LQD), which still offers an attractive 4.75% yield – better than most Treasury bonds.
For higher yield and higher risk,iSharesiBoxx $ High Yield Corporate Bond (NYSEArca: HYG), PowerShares Fundamental High Yield Corporate Bond (NYSEArca: PHB) and SPDR Barclays Capital High Yield Bond (NYSEArca: JNK) might be right up your alley. All three offer yields currently well above 7%.
International Treasury Bonds
Last, but certainly not least, is the international Treasury bond space.
Thanks to their low correlation with U.S. debt, such bonds can help you further diversify your clients’ portfolios while giving them exposure to fixed-income markets outside the United States.
This market was thrust into the spotlight in 2010 as the European debt crisis deepened, and it could become more appealing as the crisis abates and investors gain confidence in the ability of troubled countries to meet their obligations.
There are two types of international Treasury bonds: developed market debt and emerging market debt.
Naturally, developed market debt has less risk, but it’s not non-existent. In fact, the troubles in Europe over the last year have underscored the fact that there are some real risks, even in industrialized nations. SPDR Barclays Capital International Treasury Bond (NYSEArca: BWX) and iShares S&P/Citi International Treasury Bond (NYSEArca: IGOV) are two examples of developed market bond funds.
Emerging market debt, like emerging market equities, also come with a certain degree of risk. But for both developed and emerging countries, the benefits of using ETFs to get this exposure are clear: by spreading the allocation across several countries instead of just one or two, the risks are reduced (but again, not gone).
PowerShares Emerging Market Sovereign Debt (NYSEArca: PCY) and WisdomTree Emerging Markets Local Debt (NYSEArca: ELD) are two examples of the exposure you can get to emerging market fixed-income.
Fixed-Income ETFs
Why would you consider owning fixed-income ETFs for your clients? That’s easy: you can get all kinds of bond exposure at a far more manageable price. If you’d rather go out and cherry-pick individual bonds, it would take a fortune to get the same exposure you could get in one easy ETF.
Further, owning bonds in ETF form takes much of the work out of your hands. For example, you don’t have to concern yourself with when issues mature.
Fixed-income ETFs also make it easy to fine-tune the exposure your clients get. As the interest rate environment shifts, you can easily make the necessary moves because ETFs are so liquid, transparent and inexpensive.
To find all the available fixed-income ETFs, select “fixed-income” from the drop-down menu on the ETF Analyzer. As a pro subscriber, you also have alerts and portfolios at your disposal.
For full disclosure, Tom Lydon’s clients own SHY, LQD and JNK.