Investors can utilize bond exchange traded funds to craft a customized fixed-income portfolio and to minimize exposure to potential risks in a changing bond market environment.
Most bond investors may have a core position in an index fund that tracks the widely used U.S. benchmark, the Barclays U.S. Aggregate Bond Index, writes Eleanor Laise for Kiplinger.
However, since the index weights holdings by market capitalization, issuers with the largest debt, in this case the U.S. government, makes up the largest position in the Index. For instance, the iShares Core U.S. Aggregate Bond ETF (NYSEArca: AGG), which tracks the Barclays US Aggregate Bond Index, includes a hefty 37.1% weight toward Treasuries, followed by 28.2% in MBS passthrough, 13.4% industrials, 7.0% financial institutions and 5.4% agencies. [Bond ETFs Provide a Buffer in Volatile Markets, Says BlackRock]
Given the stubbornly low rate environment, with benchmark 10-year Treasuries yielding about 2.35%, bond investors are not being rewarded for the amount of rate risk they are exposed to.
In contrast, actively managed intermediate-term bond funds have cut their Treasury exposure and raised their corporate debt profiles while cutting down their duration. The strategy has been working with most active bond funds beating the benchmark index over the past couple of years.
Paul Bosse, principal in the Vanguard Investment Strategy Group, found that the portfolios of active funds benchmarked to the Aggregate index have over the past 15 years maintained an average corporate-bond allocation that’s about double the index’s weighting.
However, Vanguard also discovered when compared to a custom-made benchmark that reflects active fund allocations, the active funds have not produced anything special. Consequently, active managers’ ability to beat the Aggregate index may be arguably due to their greater credit risk.
With ETFs, the average retail investor can also potentially enhance returns through corporate debt exposure at a lower cost. Bosse argues that investors can get a cheaper version of the risk and return of active managers by pairing an Aggregate Index fund with a low-cost corporate bond index fund.
For instance, the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEArca: LQD), iShares Intermediate Credit Bond ETF (NYSEArca: CIU) and Vanguard Intermediate-Term Corporate Bond ETF (NYSEArca: VCIT) all provide exposure to investment-grade quality corporate debt. [Bond ETFs for Income Generation While Hedging Rate Risks]
LQD has a 0.15% expense ratio and a 3.10% 30-day SEC yield. CIU has a 0.20% expense ratio and a 2.03% 30-day SEC yield. VCIT has a 0.12% expense ratio and a 3.08% 30-day SEC yield.
There are 282 U.S.-listed bond ETFs on the market with an average expense ratio of 0.41%, according to XTF data. Boccellari points out that the low fees are also a good way for income-minded investors to keep more of the yields for themselves, as opposed to forking over a 1% fee for active managers.
For more information on the fixed-income market, visit our bond ETFs category.
Max Chen contributed to this article.