Which Fixed Income ETFs Are Relatively Safe?

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 |  Includes: AGG, BND, BSV, CSJ, CWB, HYG, IEF, JNK, LQD, MBB, MUB, PCY, PST, SHY, SPY, TBT, TIP, TLT
by: Hao Jin, CFA
Men think in herds; they go mad in herds, while they only recover their senses slowly, and one by one, according to Erin Arvedlund, author of Too Good to be True.
As the S&P 500 quickly approaches its resistance level of 1200, some investors are voicing skepticism about equity valuations and about stock markets’ ability to sustain themselves. More and more people are looking for stable, safe income from their fixed-income investments. In addition, an aging investor population also creates secular demand for high-quality fixed-income securities.
Banks pay almost no interest on deposits, leaving bonds and real estate as pretty much the two main options for fixed-income investors. Bond ETFs are a good way for the average investor to have diversification and flexibility. But those ETFs turned out to be more volatile than expected. Which ETFs are relatively safe?
Biggest Risk for Fixed Income Is Inflation
Bond prices overall will decline when interest rates rise. The average long term Treasury rate from 1870 through 2009 is 4.3% and the average annual CPI for the same period is 2.1%. The following chart from Yahoo shows 10-year-treasure rate since 1962:
click to enlarge
Click to enlarge
One way to reduce growing government debt is to boost prices and wages, issue tax rebates and erode the value of the currency. However, inflation could create lots of problems for the government itself. For example, a lot of government spending such as social security, pensions, and even Treasury Inflation Protected Securities (TIPS) are directly tied to inflation. So when inflation rises, so do government obligations, unless the government is going to exclude more and more items from “Core Inflation”.
Credit Rating
On the day of the Bear Sterns failure, Moody’s maintained a rating for Bear Stearns of A2; S&P gave an A rating until the day of failure. Fitch said it continually merited a solid A+ till March 24, 2008.
Even though people don’t trust ratings agencies as much as they used to, credit rating is still one of the biggest components when you compute a bond's value.
52-Week-Price-Range
Bond ETFs’ prices fluctuate within a wide range. One way to measure bond’s volatility is Standard Deviation. A more intuitive way is to compare 52-week-highs vs. 52-week-lows. S&P 500 (NYSEARCA:SPY) has 52-week-high/52-week-low ratio of over 151%, while short-term bond ETFs such as SHY only have a ratio of 102%. By the way, SHY’s Standard Deviation is around 2%.
10 Main Fixed Income ETFs (by Net Assets)
Followings are main bond ETFs, including federal, municipal government, corporate, high yield, MBS, convertible and international bonds funds:
Fund Name (Ticker)
Yield
52-Wk-High / Low
iShares Barclays TIPS Bond (NYSEARCA:TIP)
2.8%
108%
iShares iBoxx $ Invest Grade Corp Bond (NYSEARCA:LQD)
4.4%
116%
iShares Barclays Aggregate Bond (NYSEARCA:AGG)
3.2%
108%
iShares Barclays 1-3 Year Treasury Bond (NYSEARCA:SHY)
2.0%
102%
Vanguard Total Bond Market ETF (NYSEARCA:BND)
3.6%
106%
iShares Barclays 1-3 Year Credit Bond (NYSEARCA:CSJ)
2.9%
107%
iShares iBoxx $ High Yield Corporate Bd (NYSEARCA:HYG)
9.2%
135%
Vanguard Short-Term Bond ETF (NYSEARCA:BSV)
2.4%
104%
SPDR Barclays Capital High Yield Bond (NYSEARCA:JNK)
11.7%
141%
iShares Barclays 7-10 Year Treasury (NYSEARCA:IEF)
3.4%
110%
iShares Barclays 20+ Year Treas Bond (NYSEARCA:TLT)
3.4%
122%
iShares Barclays MBS Bond (NYSEARCA:MBB)
3.0%
111%
iShares S&P National AMT-Free Muni Bd (NYSEARCA:MUB)
3.0%
110%
PowerShares Emerging Mkts Sov Debt (NYSEARCA:PCY)
6.3%
129%
SPDR Barclays Capital Convertible Bond (NYSEARCA:CWB)
4.3%
132%
Click to enlarge
If you want to short bonds, you might use UltraShort 20+ Year Treasury ProShares (NYSEARCA:TBT) or UltraShort 7-10 Year Treasury ProShares (NYSEARCA:PST).
Comparison between 4 Main Bond ETFs
Ticker
Net Assets
Expense Ratio
SEC Yield
Maturity (Yr)
Credit Rating
TIP
19.9B
0.20%
0.8%
9.1
AAA
LQD
12.3B
0.15%
4.6%
12.1
BBB+
AGG
11.4B
0.24%
1.8%
5.9
AAA
BND
7.0B
0.14%
3.3%
6.6
Aa1/Aa2
Click to enlarge
Even though TIP’s weighted average maturity is over 9 years, its effective duration is only 3.6, while IEF's duration is 7.15. Duration is a measure of the sensitivity of bond (or bond fund) prices to interest rate movements.
Canadian Bond ETF
The iShares CDN Bond Index Fund consists of investment-grade Government of Canada, provincial, corporate and municipal bonds issued domestically in Canada and denominated in Canadian dollars. It is traded on Toronto Stock Exchange under ticker symbol of XBB.
Fund Name (Ticker)
Yield
% of AAA/AA/A Ratings
iShares Barclays Aggr Bond (AGG)
3.2%
90%
iShares CDN Bond Index Fund (XBB.TO)
4.5%
92%
Click to enlarge
76% of AGG consists of US government or AAA rated bonds, while only 50.6% of XBB’s holdings are rated AAA.
Conclusion
According to an article published in CFA Institute Conference Proceedings Quarterly March 2010 issue titled “The Debt Deflation / Inflation Debate”, history shows that deflation follows deep recession regardless of the fiscal or monetary policy used to address the nation’s economic woes. As Irving Fisher asserted, over-indebtedness eventually creates a deflationary economic environment because it causes a decline in asset values and results in distressed selling.
If you are not concerned about inflation, iShares Barclays Aggregate Bond (AGG) or Vanguard Total Bond Market ETF (BND) offer higher returns than TIP. These 3, plus short-term treasure ETFs such as SHY, are less volatile than rest of the bind ETFs.
However, rising interest rates can depress the prices of all bonds, and a quick move up in rates could effectively erase the few percentage yields due to the potential price drop. Last week the 10 year treasury rate was up to 3.85. The rising of rates may forecast some inflationary pressures down the road.
Disclosure: Long SPY, TIP and XBB.TO. Data is from iShares, Vanguard and Yahoo Finance and is valid as of March 26, 2010.