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Buy a bond ETF and you'll get hundreds of bonds in one package. But that package may not be as diversified as it looks when it comes to a key risk these days: rising interest rates.
Bond prices fall when interest rates rise, and rates have surged in recent weeks; the yield on the benchmark 10-year Treasury note has jumped to about 2.5% from 1.66% in early May.
That has pressured many bond ETFs, including the largest one on the market, the iShares Core Total U.S. Bond Market ETF (AGG). The $15 billion ETF — which tracks the Barclays U.S. Aggregate Bond Index or "Agg" — has lost about 2.5% this year. And further rate increases could take a heavy toll.
About 43% of the AGG ETF now consists of U.S. government bonds, up from 34% in 2007, according to iShares. That has made the AGG more sensitive to changes in rates, says Geoff Considine, head of Quantext, a portfolio software design firm in Boulder, Colo.
Indeed, if rates rise by one percentage point, the share price of the AGG ETF would lose five points, according to data from iShares. That would wipe out more than two years of interest income at the fund's recent yield of 2.1%.
Granted, predicting the path of interest rates isn't easy. The Federal Reserve has announced plans to taper its bond buying program later this year if the economy keeps improving — news that sent the bond market into a tailspin. Yet the Fed is still aiming to keep rates low and may ramp up bond purchases if rates rise much higher. In that scenario, the AGG would likely hold up well.
Moreover, the issue for investors isn't so much the direction of rates as the magnitude of a move, says Anthony Parish, vice president for research with Sage Advisory Services, an Austin, Texas-based investment advisory firm.
Bond fund managers can adapt to a slow upward move in rates by adjusting their holdings, he says. Protecting against a big, sudden rise in rates — like in 1994 or the surge in recent weeks — is tougher. Either way, "with Treasury yields near historic lows, interest-rate risk is a concern of all bond investors," Parish says.
Diversifying more broadly across the U.S. and global bond and fixed-income markets may help, he says, adding investors may want to consider non-traditional income sources such as preferred stocks and floating rate bank loans, which can be "very defensive" in a rising rate climate.
For ETF investors, the AGG may still work as a defensive, bedrock investment. But some advisers suggest layering in other ETFs to lower interest rate risk and squeeze out a bit more income.
One such "model portfolio" from Quantext's Considine has a 46% allocation to the AGG. The rest is divided between ETFs that focus on high-yield debt, municipal bonds and convertible debt (see chart).
Compared to the AGG, this portfolio should hold up better if rates continue to rise, according to his computer simulations. Investors can boost their overall portfolio yield to 2.9% from roughly 2.1%. And the portfolio should be slightly less volatile than the AGG, he says.
The downside: Investors face higher transaction costs with multiple ETFs. The total expense ratio is higher than the AGG ETF, which has an annual fee of 0.08%. The portfolio trades interest rate risk for credit risk: a potential drop in bond prices due to a weaker outlook for muni bonds or corporate debt, or the broader economy.
Another approach: Avoid the AGG altogether. Sage Advisory Services, the investment firm in Texas, offers a "core plus" ETF portfolio that consists of 17% Treasuries, 36% mortgage-backed securities and the rest in high-yield and corporate bonds, preferred stock and emerging market debt (see chart).
The portfolio is less sensitive to interest rates than the AGG, says Parish, and it yields around 3.1%, according to the latest 30-day SEC yields. That beats the AGG's yield, and the portfolio's volatility should be similar, he adds.
The downside: The portfolio takes more credit risk than the AGG. Buying the seven ETFs in the portfolio would impose higher transaction costs and annual fees. The portfolio is designed to outperform the AGG over the next three to six months, says Parish, but it may need to be adjusted as bond prices and yields change.
In the mutual fund space, strategic or "total return" funds are another option for a core bond position. These funds tend to hold more high-yield and corporate bonds than the AGG. And they may layer in non-traditional securities like "collateralized" mortgage bonds that aren't backed by the government.
That can make these funds riskier from a credit perspective, but they aren't necessarily more volatile than the AGG.
The DoubleLine Total Return Bond Fund (DLTNX), for instance, is less volatile than the AGG with a lower annual "standard deviation," according to Morningstar. Lead manager Jeffrey Gundlach invests about a third of the fund in "non-agency" mortgage securities — a somewhat riskier part of the market. But the rest of the fund is largely in government-backed securities and cash — a "barbell" strategy that may cushion the blow if risky assets sell off.
Overall, returns have been solid: The fund returned an average 9.4% over the past three years, beating 98% of peers, according to Morningstar. The fund's duration — a measure of sensitivity to interest rates — is lower than the AGG, according to Morningstar. And the fund yields more than the AGG with a 30-day SEC yield of 5.3%.
The downside: The fund's performance could suffer if mortgage-backed securities decline. Given the complexity of the portfolio, "it's difficult to gauge the risk a market shock could have on the fund," Morningstar analyst Sarah Bush wrote in a report on the fund.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.
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