4 Reasons Investors Shouldn't Rely on Fixed Income ETFs

As the ETF industry has expanded in recent years, a significant percentage of the expansion has come from equity ETFs embracing new regions and investment styles and from commodity funds offering small investors exposure to resources that were previously available only to the ultra-rich (although position limits are threatening to restrict access to numerous commodity funds). Despite the importance of fixed income instruments in investor portfolios (as proven by their performance relative to stocks during the recent downturn), fixed income ETFs lag behind their equity counterparts in terms of number of funds. According to our ETF Database, there are currently about 70 fixed income ETFs, compared to more than 600 equity funds.

As worries about the ability of fixed income investments to perform inside of an exchange-traded structure have been shown to be unfounded, we are beginning to see an increase in bond ETF activity. According to State Street’s July ETF snapshot, 10 new funds have been launched this year, and fixed income ETFs have seen assets grow by almost $26 billion.

Two of the most popular fixed income ETFs are the iShares Barclays Aggregate Bond Fund (AGG) and the Vanguard Total Bond Market ETF (BND). These “total bond market” ETFs offer diversified exposure to the U.S. bond markets, prompting many investors to achieve a significant portion of their fixed income investments to a single ETF.

But while AGG and BND are well-diversified, very liquid, and cost-efficient, gaining your fixed income exposure exclusively through one of these “one stop shop” ETFs is a very common investing mistake. Don’t get me wrong – AGG and BND are excellent products (I recently upped my stake in AGG) – but they aren’t the last word in fixed income investing. Here are four reasons why investors should avoid relying too heavily on one of these fixed income ETFs:

1. Significant Allocation to Treasuries and Government-Sponsored Securities: According to its most recent fact sheet, AGG allocates more than a quarter of its holdings to U.S. Treasuries, and nearly 50% to securities issued by FNMA, GNMA, FHLMC, and other U.S. government-sponsored agencies. If investors are particularly bullish on Treasuries, AGG offers a significant amount of exposure. But many investors would be better served to hold a higher percentage of their fixed income portfolio in corporate bonds and other fixed income instruments with higher yields.

2. No Exposure to High Yield Bonds: AGG and BND offer exposure to the total investment grade U.S. bond market, meaning that they invest primarily in debt issues that are above a certain rating (BBB- by Standard & Poor’s and Baa3 by Moody’s). Bonds rated below these cutoffs (also known as “speculative” or “junk” bonds) carry a higher risk of default, and as such generally offer a higher rate of return. If upgraded to investment grade status, high yield bonds can see a narrowing of their credit spread and a jump in price. There are several high yield bond ETFs available, including:

• SPDR Barclays High Yield Bond ETF (JNK)
• PowerShares High Yield Corporate Bond Portfolio (PHB)
• iShares iBoxx $ High Yield Corporate Bond Fund (HYG)

3. Shortage of Inflation-Protected Securities: Inflation-protected securities have become increasingly popular among investors in recent months, as concerns over inflation resulting from the massive stimulus plans have ramped up. Total bond market ETFs have limited holdings in inflation-protected securities, indicating that the real returns on these securities may be negatively impacted if we experience a significant uptick in inflation (as many analysts fear we may). Although inflation-protected securities have some limitations (such as alleged under-reporting of CPI figures), they should be a component of any investor’s portfolio. ETFs offering exposure to inflation-protected bonds include:

• iShares Barclays TIPS Fund (TIP): Maintains a market capitalization of more than $15 billion.
• SPDR DB International Government Inflation-Protected Bond ETF (WIP): Holds inflation-protected bonds issued by foreign governments.
• SPDR Barclays Capital TIPS ETF (IPE): Maintains an expense ratio of only 0.18%.
• Pimco 1-5 Year U.S. TIPS Index Fund (STPZ): The second ETF offering from Pimco, STPZ offers exposure to low duration TIPS.

4. Light on the “Exotic” Fixed Income Offerings: When most investors think of bonds, Treasuries and corporate bonds are generally the first instruments that come to mind. But the universe of bond investments hardly stops there. Municipal bonds, emerging market bonds, and convertible bonds are but a few of the less traditional fixed income instruments that may deserve consideration from some investors (for more information, check out our guide to fixed income ETF investing).

Part Of The Answer

In my opinion, total bond market ETFs such as AGG and BND should account for a major portion of every investor’s portfolio. But they shouldn’t represent the entirety of fixed income exposure. One-stop shopping for your bond fill, while convenient and cost-efficient, isn’t practical for most investors looking to tailor their portfolio to their specific circumstances.

Jimmy Atkinson contributed to this article.

Disclosure: Long AGG, JNK.

Comments

[djj420:]

All my bond exposure is thru RPSIX and GIM. I'm short long dated treasuries via TBT. AGG and BND are both too correlated to the US$ for my taste.

Aug 28 08:36 AM

[Bradley Flu...:]

It is difficult to see a future without rising inflation expectations WIP and TIP belong in most fixed income portfolios at some level. I am long both as strategic long-term allocations to fixed income. Really appreciate the development of the fixed income ETF products. Currency ETFs make excellent tools to diversify cash holdings for small and mid market institutional clients.

Great tools these ETFs!

Aug 28 09:07 AM

[mbkelly75:]

For a long time - TLTs were the Bond portion (sort of) and I did well with them - earlier this year - TLTs went way up and Corporates went down. I sold my TLTs for a very good profit and went into Corporate Bonds (LQD) and have done well with them also. I like Bonds to make up 34% of my portfolio and LQD was about 24% so I added 10% JNK. The two ETFs together have done quite well and provide monthly income that is set to automatically re-invest in the instruments that paid them. If I need the cash for some reason - one click on my account gives me the cash instead of re-investing. It works well for me. ETFs have made bond investing MUCH easier than it was over 50 years ago when I started investing.

Aug 28 10:59 AM

[whidbey:]

I run 30/70 bonds and have been able to average about 8% appreciation and earnings. Not great but easy and secure, I think so far anyway, I hope.


I use SHY, AGG,LQD and VFIIX for fixed income. Later when the inflationary spiral starts I will switch to TIP, but more likely ACITX which is diversified internationally but expense ratios are higher too.

Thanks I like this post very much.

Aug 28 05:01 PM

[User241885/...:]

Please check the dividend history on both TIP and IPE before talking up the fixed income aspect on ETF's. Barlclay's TIP paid no dividend after the October 1st payment up through the end of March. State Street's IPE paid no dividend also starting after October 1st through the end of July. What kind of fixed income is that when the dividend is fixed at zero?

About a year ago, as oil began its plummet from $147 and the credit crisis began to unravel financial markets, many people bought into TIPs ETFs hoping they would have a chance to buy them at a lower price for the first time in a year and would get paid waiting for inflation to return. To everyone's suprise, the price barely budged but the income completely stopped. I am quite sure the underlying TIPS bonds never missed making payments during those five to eight or so months.

The problem with ETFs is that everyone understands what they are supposed to do but no one talks about what they have actually done. The sponsor banks do a great job marketing vapor. Since no one has been able to predict for the last year whether or not we are going into inflation or deflation, you have to be able to know how the particular ETF is going to perform. What we have seen so far starting last year with TIP and IPE does not give me a lot of confidence.

As a fiduciary, you need to dig a little deeper before you can buy into a story about how great the investment will perform during inflation without first having reviewed how these ETF's have actually performed. While most writers are happy to leave it at that, if it was your client's money, your family's money or your own money, you would want to know the whole story.

FAMCO

Aug 28 05:38 PM

[bearfund:]

Not sure where you've been the last six months but bonds don't yield anything any more. All the money to be made with these instruments was made by buying them when underpriced. The actual yield is crap, not worth anything especially with the Fed printing the way it is. Bonds are for trading only. If you have more than a few months' duration in your portfolio you are setting yourself up for a large loss in purchasing power over the lifetime of your investments. And if you have short-term paper you aren't getting any income anyway so you might as well store that money in gold. Boring, I know, but it's what the market is telling you to do. Listen to the market.

Aug 29 02:26 AM

[AuGod!:]

Some questions, time permitting, for authors Michael and Jimmy and interested commenters. The August 23rd remarks are quoted for convenience and because I cannot put (no pun intended) it better.

Do you think that ETFs should always be protected with Puts?

I am also curious about Gold ETFs and the strategy sketched below as I read today that while a dip is probable " ... gold is expected to break out to the upside and embark on a significant uptrend soon, so our strategy is to go long gold, possibly gold ETFs, and selected gold stocks and to protect these positions with cheap Puts, but the possibility also exists for skilled traders to go for a straddle option strategy, the idea being that the gains on the Calls should far exceed the losses on the Puts, the Puts being bought as insurance in case gold breaks down - if it does the Puts should be liquidated once they have made sufficient gains to cover the cost of the Calls. This strategy, which assumes the Puts are not being used to protect long stock positions, could be very profitable indeed in a whipsaw situation, as if the Puts are sold when they have gained enough to cover the cost of the Calls, and the market then rapidly reverses to the upside, which is what we would expect, the Calls will have been obtained for nothing." (Thanks to Clive Maund)

Worth another moment or two perhaps, is his conclusion: (again thanks to Clive)

"To conclude: the time is thought to be ripe to go flat out long gold and gold related investments. This is a train you can and should board BEFORE it starts to leave the station. However, there remains the risk that gold could instead break to the downside first but if it should do so there is thought to be a high chance that it will be the handiwork of Big Money deliberately shaking small investors out before a breakout to new highs. Although the gold COT did show a marked improvement last week, Commercial short and Large Spec long positions are still at a higher level than we would like to see ahead of an upside breakout. The latest Silver COT in contrast shows a marked increase in Commercial short positions and Large Spec long positions, adding weight to the argument that we had earlier set out to the effect that Big Money may be planning to ambush the little guy before the Precious Metals start their next major uptrend. Accordingly long gold, ETF, and stock positions should be protected by out-of-the-money Puts (ETFs should in any event be protected with Puts), which are or should be cheap at this time due to the recent low volatility, which need not be in the same security - for example GLD Puts can be used to protect bullion. Straddle option positions are very attractive at this time for traders with the appropriate level of experience and understanding as gold has essentially been in a giant trading range for 20 months, and is approaching the apex of a 6-month long Triangle, making a big move probable soon. In the event of a sharp drop the Put side should be sold once the cost of the Calls is covered - the Calls are then free."

Thnk you for your time and courtesy.

Aug 29 05:14 PM

[mbkelly75:]

Do you think that ETFs should always be protected with Puts?

In words of one syllable or less - NO! Options can be a handy tool and are useful for several things - but should not ALWAYS be used for anything no more than a hammer should be used for anything that needs a tool of any kind.

If you treat your portfolio as a true portfolio rather than a group of individual investments - options are not needed for this purpose. For instance, my portfolio is 34% Bonds, 16% Gold and Silver (represented by CEF) and 50% Dividend-Paying Stocks and MLPs.
These ALL move in low correlation with each other. When one of them gets out-of-balance within the portfolio - I re-balance to correct it. I buy more of what is lower and (unless I am adding enough cash already - I still add cash monthly) sell some of what is higher to make the difference. This has the advantage of forcing me to sell high and buy low without using options. I check to see if the portfolio needs re-balancing every 2 weeks. Doing this also means that I do not need to check the portfolio daily (Although I do most of the time anyway.) - checking it every 2 weeks is enough in just about any market. It works well for me. Think about it.

Aug 30 08:12 PM

[AuGod!:]

Thanks and Regards to mbkelly.

"Do you think that ETFs should always be protected with Puts?

In words of one syllable or less - NO! Options can be a handy tool and are useful for several things - but should not ALWAYS be used for anything no more than a hammer should be used for anything that needs a tool of any kind.

If you treat your portfolio as a true portfolio rather than a group of individual investments - options are not needed for this purpose. For instance, my portfolio is 34% Bonds, 16% Gold and Silver (represented by CEF) and 50% Dividend-Paying Stocks and MLPs.
These ALL move in low correlation with each other. When one of them gets out-of-balance within the portfolio - I re-balance to correct it. I buy more of what is lower and (unless I am adding enough cash already - I still add cash monthly) sell some of what is higher to make the difference. This has the advantage of forcing me to sell high and buy low without using options. I check to see if the portfolio needs re-balancing every 2 weeks. Doing this also means that I do not need to check the portfolio daily (Although I do most of the time anyway.) - checking it every 2 weeks is enough in just about any market. It works well for me. Think about it."

Aug 31 09:18 AM

[Mad Hedge F...:]

tyujk. It’s time to take another look at the short US Treasury bond ETF (TBT). I first recommended this 200% leveraged bet that long dated bonds were going down big time in January at $35, catching a near double to $60 (click here for report) . We have now retrenched back to $45, and it’s time to reload the boat. The US government has now committed to $9.1 trillion in debt issuance over the next ten years. Foreign governments will need to borrow as much to fund their own bail out/stimulus programs. Did I mention inflation? There is absolutely no way the ten year can maintain a 3.40% yield in the face of this onslaught. It is clear that zero short rates are driving investors, many of whom will only buy Treasuries, into making terrible investments. This is what the awesome bid to cover ratio of 3.2X for today’s three year auction is telling you. The dollar clearly sees this and is hitting a new one year low. It’s just a matter of time before bond investors put on their bifocals and see the locomotive that is about to run over them.

Sep 09 01:25 PM