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By Timothy Strauts

We often encounter investors who own as many as eight different funds to cover their equity exposure but only one or two bond funds for their fixed-income exposure. Conventional asset allocation theory dictates that investors should have at least 30% of their portfolio in bonds. We find it perplexing that investors don't show the same level of attention and differentiation to the fixed-income portion of their portfolio as they do their equity stakes. This disproportionate tilt toward completely passive investing in fixed income could be the result of less familiarity to the composition of the Barclays U.S. Aggregate Bond Index, which is the most widely followed U.S. bond index. The two largest ETFs that track this index are iShares Barclays Aggregate Bond (NYSEARCA:AGG) and Vanguard Total Bond Market (NYSEARCA:BND). Many investors buy these funds for their entire bond allocation because both offerings offer a simple way to get access to the U.S. bond market in a low-cost package.

There is nothing wrong with simplicity; in fact, the benefits can be immeasurable. However, the current composition of the Barclays U.S. Aggregate Bond Index may surprise some investors. This index replicates the U.S. investment-grade-bond market based on market weight, so bond types with the most issuance have the highest weight in the index. The current index consists of 44% U.S. government securities (Treasury/agency), 30% mortgage securities, 19% corporate securities, and 7% foreign securities. The index has been a great choice for investors over the past 10 years, as it has returned 6.04% per year. The main reason for this performance is a period of declining interest rates. In the last decade, the 10-year Treasury yield has gone from 6.02% in July 2000 to 2.96% today. Investors need to consider that, at some point, yields can't go lower, and will start to rise. When this will happen is unknown, but you can start to prepare your portfolio today.

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The table above is a diversified bond portfolio made up of bond ETFs focused on individual market segments. It offers more diversified exposure and reduces the overweight positions in U.S. Treasuries and mortgage bonds. Using ETFs to create your own bond portfolio can help reduce large overweight positions in the index, incorporate investments not represented in the index, and allow you to tailor the portfolio to your own unique risk tolerance and time horizon. That being said, our weighting strategy provides a fundamentally similar portfolio to the Barclays U.S. Aggregate Bond Index, but you can easily adjust the results on your own by changing the weightings. The overall portfolio presented above has a duration (a measure of interest-rate sensitivity) of 4.7 years, which is similar to the index's duration of 4.5 years. The portfolio's distribution rate is 4.06%, which is higher than the index's 3.33%. On average, the portfolio has lower credit quality but is still investment-grade.

Let's review the holdings and discuss the rationale for each selection:

iShares Barclays 3-7 Year Treasury Bond (NYSEARCA:IEI)
IEI was chosen among many Treasury ETFs because of its similar duration to the broad index. A 15% holding reduces the U.S. Treasury and agency exposure by 29%. With the great performance of government bonds over the past 10 years and historically low interest rates, it may make sense to reduce exposure to this area of the market. While not an immediate concern, IEI, with a yield of 1.8%, provides no protection from inflation in the future. Long-term inflation, since 1925, averages about 3% per year.

iShares Barclays TIPS Bond (NYSEARCA:TIP)
Treasury Inflation-Protected Securities, which are not part of the Barclays U.S. Aggregate Bond Index, offer a yield that adjusts depending on increases or decreases in inflation. The current five-year TIPS break-even rate (the yield spread between a five-year TIPS bond and a five-year Treasury note) is at 1.62%. This means the market is expecting an inflation rate over the next five years of 1.62%. An investment in this ETF will provide a hedge if the market is wrong and inflation is higher. By investing equal amounts in this ETF and IEI, we are attempting to neutralize our position on inflation or deflation.

iShares Barclays MBS Bond (NYSEARCA:MBB)
The mortgage-backed securities in MBB are rated AAA because they are backed by the U.S. government. Investors might be wary of investing in mortgage bonds considering the current real estate market problems, but the key feature of bonds issued by Fannie Mae and Ginnie Mae is that they guarantee payment of principal and interest. So, even if a large percentage of homeowners default on their mortgages, the bonds will still pay their interest payments on time. The high-quality nature of the portfolio means it will have similar returns to a U.S. Treasury bond over the long term. Over the last three years, MBB has had a 0.69 correlation with IEI. Mortgage bonds carry prepayment risk because homeowners have the ability to pay more than the minimum payment or pay it off completely in a refinance. However, an efficient market predicts the level of prepayment when pricing a mortgage bond. If interest rates rise unexpectedly, there will be lower prepayments than forecast, because fewer people will be able to refinance, and returns will suffer. Investing 20% in MBB compared with 30% in the index will allow the portfolio to diversify into other areas less correlated with U.S. Treasuries and with lower risks in the event that interest rates rise.

iShares Barclays Credit Bond (CFT)
CFT is composed of about 80% U.S. corporate bonds and 20% non-U.S. sovereign bonds denominated in U.S. dollars. IShares iBoxx $ Investment Grade Corporate Bond (NYSEARCA:LQD) is the more popular fund in the category, with over $13 billion in assets. However, we chose CFT because of its lower duration and exposure to non-U.S. sovereign bonds. The broad index includes non-U.S. securities, so we don't want to exclude them from the portfolio. The 30% weighting is only slightly higher than the 26% allocation (19% corporate and 7% foreign securities) in the broad index. Corporate bonds, because of higher credit risk than their U.S. government counterparts, carry a higher relative yield, which helps returns if interest rates rise.

SPDR Barclays Capital High Yield Bond (NYSEARCA:JNK)
High-yield bonds are not included in the Barclays U.S. Aggregate Bond Index, but they can be an important portfolio diversifier. The correlation between JNK and IEI has been negative 0.26 since April 2008. JNK offers an enticing yield of 8.6% but owns low-credit-quality bonds. There is opportunity in high-yield because many of the weakest firms went bankrupt in 2008 and 2009. The companies that were able survive the credit crisis are stronger now and likelier to continue making their debt payments. Moody's expects the high-yield default rate to drop to 2.4% by the end of the year. This contrasts a default rate of 11.1% in 2009. If the economy continues to grow, high-yield will do well in the future.

WisdomTree Emerging Markets Local Debt (NYSEARCA:ELD)
ELD is composed of government bonds from emerging-markets countries. The bonds are denominated in local currency, so investors need to be aware of the foreign currency risk associated with this fund. Emerging currencies have been steadily rising versus the U.S. dollar in the past few years and, if the trend continues, it will add to the returns of ELD. The fund follows an active strategy that seeks to put a higher percentage of assets in the countries that maintain strong fiscal discipline. Emerging markets, which have historically been considered riskier, currently have lower debt levels and better GDP growth rates than most of the developed world.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: Create Your Own Bond Portfolio Using ETFs