High Yielding Retirement Strategy Utilizing Bond ETFs

Feb. 9.09 | About: iShares Core (AGG)

Based on historical patterns, the following list of dividend-paying asset classes is a good starting point for retired investors wishing to construct a well-diversified retirement portfolio for income.

Perhaps one of the most controversial, yet intriguing, asset classes currently for income investors is high yielding corporate bonds. High yield bonds, or junk bonds, are simply debt instruments issued by corporations with credit ratings of less than BBB. Investment grade bonds are rated AAA, AA, A and BBB by Standard & Poor’s. Any bond rated below BBB is considered less than investment grade meaning high yield or junk bonds. Interest rates on high yield debt now exceed Treasury bond yields by 18-20%, according to Barclays High Yield Corporate Options Adjusted Spread Index. The previous peak was a spread of 11-12% during July 2002, at the recession trough. Spreads dropped to an August 2007 low of just over 2%, but have recently skyrocketed again.

One of the significant risks to investors in high yield debt investing is the risk of default by the issuer, either on interest payments or principal. Investing in a mutual fund of high yield bonds (either open-end or closed-end) or in exchange traded funds spreads your risk over many issuers and is the best way to ameliorate default risk. Another way to mitigate risk in high yield investing is to buy when default rates are high or seem to be peaking. An historical perspective is useful to evaluate default risk.

The Great Depression, from 1930 to 1935, experienced 9% defaults with 1933 witnessing a 15.4% peak in defaults. Various recessions in the 70s and 90s saw peak defaults of 8.8% and 9.9% respectively. According to Fitch Ratings, 2001 to 2002 saw defaults skyrocket to nearly 15%. Fitch now forecasts that high yield bond defaults in 2009 and 2010 may challenge the 2002 and 1933 peaks. Furthermore, Moodys forecasts that current implied defaults, based on historically high spreads exceeding 18% (the difference between U.S Government bond rates and High Yield Corporate bond rates), spreads may even exceed 21% this year or next.

With all the current discussion about credit risk today, many of our readers at www.AboutETFs.com have shown increased interest not only in U.S. Government-backed bonds, but in Corporate bonds as well. So, should you shift entirely out of corporate bonds, even investment-grade bonds, and move all of your bond allocations into U.S. Government paper?

For ultimate safety of principal, of course, one should indeed stick with treasury bills, notes or bonds. The rub is in the yield, or lack thereof. With current yields on T-bills at 0.25% or lower, we do not see the risk-reward value. Why not have your cake and eat it too? How about considering a hybrid solution of blending ultra safe, short U.S. Government bonds, with short and intermediate term investment-grade corporate bonds? In addition, you might include, in small allocations, non-investment grade corporate bonds as well. This strategy will allow you to dramatically improve your investment income, but spread your risk over three distinctly different asset classes. This is a modern day version of the familiar old saying; never put all of your eggs in one basket!

Here are our thoughts on several different ETF selections that may provide you just the right blend of treasury bonds and corporate bonds, both investment and non-investment grade. In the ETF universe today, several obvious selections surface immediately. Three index ETFs currently track the Barclays Aggregate Bond Index:

Each of these three ETFs attempts to replicate the Barclays Capital US Aggregate Bond Index, which is diversified into three asset classes:

  • Treasury and Agency bonds (approximately 37%)

  • Mortgage-backed securities (38%)

  • Investment-Grade Corporate Bonds (25%)

Maturities in this index are relatively short with 39% of the portfolio maturing in one year or less and another 34% maturing in less than five years. The average maturity is currently 6.8 years.

The StateStreet Global Advisors LAG: SPDR Barclay’s Aggregate Bond ETF, with its modest $10 million market cap and low trading volume of 31,000 shares daily, should probably be avoided. While the Vanguard BND: Vanguard Total Bond Market is an excellent choice, our vote goes to Barclays AGG: iShares Barclay’s Aggregate Bond Index. AGG is the king of the hill with its $9.7 billion market cap and daily 800,000 shares average trading volume.

2008 performance and yield of the Barclays Aggregate Bond Index and its three index tracking ETFs were excellent. From the Lehman Brothers collapse on September 15, 2008, to the market trough on October 10, 2008, AGG dropped 14.9%, BND lost 14.2% and LAG was down 16.6%.The ensuing recovery into early January was quite dramatic. AGG and BND recovered 21% and 18% respectively, and LAG bounced back 26%. Through February 6, 2009 – AGG, BND and LAG have dropped a modest 3.6%. Current distribution yields are 4.6% for AGG, 4.5% for BND and 3.8% for LAG.

There is one primary candidate for a 100% investment-grade corporate bond ETF, LQD: iShares iBoxx $ Investment-Grade Corporate Bond Fund. By holding 100% in corporates, as expected, the current distribution rate trumps our three hybrid government or corporate selections. LQD is distributing a robust 5.6%, but this higher yield has come at a cost. In the three weeks following the September 15, 2008 Lehman Brothers bankruptcy, LQD plunged 25.4%, nearly matching the 32% S&P 500 decline. By January 9, 2009, LQD shot up 35% from its October 10, 2008 low. Recently, LQD has fallen back about 5% from its peak value earlier in January.

LQD seeks investment results corresponding to the price and yield performance of the iBoxx $ Liquid Investment-Grade Index. This index measures the performance of 100 highly liquid, investment-grade, U.S. Dollar-denominated corporate bonds that offer maximum liquidity and represent the broader U.S. corporate bond market. The average duration of bonds held by LQD is 6.25 years, daily trading volume exceeds 800,000 shares and its market cap is $3.7 billion.

Other helpful links:

· AboutETFs.com

· Barclays Global Investors iShares

· ETF Connect.com: (history, charts, summary information)

· Forbes Digital Company Investopedia: (articles, definitions, asset classes)

· Index Universe Data Query: (section on ETFs: sort ready for spreadsheets)

· SeekingAlpha ETF articles

· Yahoo Finance ETF Center