Fixed income plays a crucial role in most investors’ portfolios because the asset class offers stability and income. On average, individual investors place more than 50 percent of their long-term savings in fixed income securities. That means proper fixed income ETF analysis and selection plays an important role in portfolio management.
Before choosing a fixed income ETF, an investor needs to decide (1) How much of their overall portfolio should be in fixed income, and (2) What type of fixed income ETF best suits their needs.
How Fixed Income ETFs Are Constructed
Some fixed income ETFs seek to track an index or underlying investment product. However, many bonds in indices are not liquid, meaning they do not trade on a regular basis. As a result, full replication of a traditional Bond Index like the Barclays Capital Aggregate Bond Index (which holds over 6,000 securities) is nearly impossible. That being the case, ETF managers attempt to reflect the risk and return characteristics of popular bond indices by sampling a basket of liquid securities that trade frequently and closely track the index.
Once a portfolio of bonds is created, the sampled portfolio is optimized and tested to see whether there is a significant difference in the past risk and return of the portfolio and the index the portfolio is trying to track. If the tracking error with the indexes is too high, bonds are replaced in the portfolio. The procedure continues until the portfolio’s tracking error is within an acceptable tolerance. A successful sampling and optimization strategy should require only a few hundred bonds to bring the tracking error within an acceptable level.
Types of ETFs
The ETF fixed income market is composed of many types of securities. They include, but are not limited to, U.S. Treasury Bonds, Mortgage-backed Bonds, Municipal Bonds, Corporate Bonds, Junk Bonds, International Bonds, Convertible Bonds, Inflation-Protected Bonds, Short-Term Bonds, Intermediate-Term Bonds, Long-Term Bonds, Leveraged Bonds, and Inverse Bonds.
Bond indexes divide maturities into three ranges. Short-term indexes hold bonds that have an average maturity of 3 years or less, intermediate-term indexes hold bonds with an average maturity of 4 to 9 years, and long-term indexes hold bonds that have an average maturity of 10 years or longer. If an index has an average maturity of 5 years, it does not mean all bonds in the fund mature in 5 years. The bonds could mature from 1 year through 10 years or any combination thereof. Read the prospectus of the ETF you are interested in so you understand how the index is designed.
Interest Rate and Credit Risk
Bond index average duration is an important characteristic that investors should monitor. Duration is a measure of interest rate risk. If interest rates move higher, ETFs benchmarked to indices with longer durations will go down more in value than ETFs benchmarked to indexes that have shorter durations. In the long term, since there is more risk in long-duration bonds, you should expect indices with long durations to generate a higher total return than indices with a short duration.
Credit risk is a reflection of the financial strength of the issuer. The higher the credit risk, the greater the chance of a default, and the higher the interest rate needs to be to compensate for that risk. The credit risk of U.S. government and government agencies is low. Corporate bonds that are investment grade are higher, and at the top of the risk level are high-yield junk bonds. These funds invest in below-investment-grade debt because they have a higher probability of running into trouble.
The important point is this: as the duration of indexes increases and as credit quality decreases, the expected long-term return of a bond index increases to compensate for those extra risks.
Choosing the Right Bond ETF for You
As with any type of investment, bond ETFs have defined risk/reward characteristics. You should determine your own risk/reward profile for the ETF portion of your portfolio and then choose Bond ETFs that correspond to that profile. For example, if you want to minimize risk, you should choose a short-duration, government bond fund. If you’re willing to take on maximum risk (within the Bond ETF market) in exchange for a higher return, you should choose a high-yield Corporate Bond ETF.
Investors in a high tax bracket might want to consider Municipal Bond ETFs because they can provide tax-exempt income and a steady income stream. While tough economic times and reduced tax revenues possibly might create difficulties for some states in re-paying municipal bonds,credit risk can be reduced by focusing on ETFs which invest in higher credit quality issuers.
Probably because fixed income instruments are generally not as volatile as stocks, most investors pay less attention to the fixed income side of their portfolio than stocks. But with ETFs now available on every duration and sector in the fixed income market, as well leveraged and inverse products, investors would be advised to at least understand the variety of Bond ETF products and how they perform in different interest rate and economic environments.