The inspiration for this article came from last year, when I wrote an article on a portfolio that had no bonds included. Therefore, I decided I thought I would try the opposite but with a slightly different objective. It is easy to create a portfolio of all bond ETFs, the problem is that many bond ETFs are highly correlated to broad bond market funds like the iShares Barclays Aggregate Bond ETF (NYSEARCA:AGG). Therefore, because of that I wanted to find the lowest or inversely correlated bond ETFs that are diversified across different sections of the fixed income market. The reason for wanting a portfolio of inversely correlated bond funds is because eventually interest rates will rise, and when they do, a broad bond fund like AGG will take a hit. Therefore, by having a portfolio of bond ETFs that will not be affected as much or as hard as a traditional broad bond market ETF will be desirable for many investors.
My Process
First, I will use the Fidelity.com ETF Screener to get my list of initial bond ETFs to check the correlations. The following list of screener criteria is what I used to find bond ETFs, then pick the ETF with the lowest correlation to AGG, for each category of bond.
Exclude Leveraged and Inverse
 ETF Type = ETF
 Asset Class = Fixed Income
 Net Assets: >$100 Million
 Volume: 90 Day average volume > 50K
 Fixed Income Debt Issue objective: Blend, Collateralized, Municipal, Federal/Central Debt, and Corporate Debt
Second, After using the screener criteria from step one, I found 11 ETFs for Blend, 2 ETFs for collateralized, 10 Municipal ETFs, 27 Federal/Central Debt ETFs, and 22 Corporate Debt ETFs. So for each ETF in each category, I found the correlation to AGG using the ETFreplay.com correlation tool, and for each category of bond, I chose the ETF that has the lowest correlation to AGG. In the first table below is my final list of ETFs with the lowest correlation to AGG for each category. In the second table below is the correlation matrix of each ETF in the portfolio to each other.
Category 
Symbol 
Description 
AGG Correlation 
Blend 
(NYSEARCA:FLOT) 
shares Floating Rate Note 
0.02 
Collateralized 
(NASDAQ:VMBS) 
Vanguard MortgageBacked Sec Index ETF 
0.32 
Municipal 
(NYSEARCA:HYD) 
Market Vectors HighYield Muni ETF 
0.04 
Federal/Central Debt 
(NYSEARCA:ELD) 
Wisdom Tree Emerging Markets Local Debt 
0.17 
Corporate Debt 
(NYSEARCA:JNK) 
SPDR Barclays High Yield Bond 
0.30 
Correlation Matrix
ELD 
FLOT 
HYD 
JNK 
VMBS 

ELD 
1 

FLOT 
0 
1 

HYD 
0.12 
0.02 
1 

JNK 
0.48 
0.05 
0.03 
1 

VMBS 
0.05 
0.03 
0.09 
0.08 
1 
Correlation matrix from [etfscreen.com]
Portfolio Performance
As I have done when creating other portfolios, I will be weighting the portfolio by volatility, so the lowest volatility ETF has the largest weighting, and the highest volatility ETF has the smallest weighting. The table below shows the weights and volatilities of each ETF in the portfolio.
Symbol 
Description 
Weight 
Volatility 
FLOT 
shares Floating Rate Note 
30% 
2.00% 
VMBS 
Vanguard MortgageBacked Sec Index ETF 
25% 
2.60% 
HYD 
Market Vectors HighYield Muni ETF 
20% 
7.40% 
ELD 
Wisdom Tree Emerging Markets Local Debt 
15% 
9.40% 
JNK 
SPDR Barclays High Yield Bond 
10% 
10.30% 
Volatility Data from [ETFreplay.com]
The following charts show the performance of the portfolio, the total return, the volatility, and the correlation of the portfolio against AGG, as well as the SPDR S&P 500 Trust ETF (NYSEARCA:SPY). For my historical performance review, I will be using the ETFreplay.com backtest tool for the data on the portfolio going back to June 17, 2011 which is far back as data goes for FLOT.
Performance Table
Correlation 
Total Return 
Volatility 
Return/Volatility 

My Portfolio 
x 
9.60% 
2.80% 
3.43% 
AGG 
0.09 
7.80% 
3.20% 
2.44% 
SPY 
+0.64 
23.50% 
19.60% 
1.20% 
Observations/Closing Thoughts
As the performance table above shows, my portfolio has a correlation of 0.09 to AGG, so it is slightly inversely correlated, which was my goal that I set out to accomplish. My portfolio provided a higher risk adjusted return, by having a higher total return and lower volatility than AGG. What really surprised me about the portfolio was the aboveaverage correlation of +0.64 to the SPY. With the portfolio having an aboveaverage correlation to the SPY, the portfolio can go up with the stock market, and limit the downside when stocks fall. Because the portfolio is negatively correlated to AGG, in market pullbacks the portfolio will not act like a traditional broad bond ETF where if stocks fall, then bonds rise. Overall, I am very satisfied with the portfolio because it accomplished my goal of being negatively correlated to AGG, and the funds within the portfolio were very diversified as the correlation matrix above shows. I was also very pleased that the portfolio had a lower volatility than AGG, which can be attributed to my weighting of the ETFs in my portfolio by volatility, to reduce the overall risk of the portfolio.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.