3 Reasons Bond ETF Bashers May Want to Recalibrate

Includes: CWB, JNK, LQD, PCY
by: Gary Gordon

One of my asset management clients recently asked me about the increasingly pessimistic bond bashing in the media. He wrote:

I understand that investors should diversify. But if bonds look like a terrible investment to the experts, why should people put their money in them?

Ahhhhh, the experts. Presumably, this fellowship includes yours truly… one of the original ETF advocates since their inception in the '90s and the primary editor at ETFexpert.com.

Well, for starters, the experts can be wrong… and I can be wrong. Yet I am not married to any investment selection or well-conceived theme.

Instead, I seek to secure a big gain, small gain or small loss on individual investment choices. By taking smaller gains or smaller losses — through stop-limit orders and hedging techniques – one avoids the big loss. Only “the big loss” can kill your portfolio’s long-term progress.

All of my clients understand my approach. Yet the fact that I have some income-oriented positions led “Mark” to ask if there are any reasons to consider bond investments at all if their outlook for 2011 is so poor.

For Mark and for my readers, here are 3 reasons to recalibrate your thinking on Bond ETFs:

  1. Nobody Can Predict the Future. Nobody!

If anyone looks back at the end of 2009, they will see that bond bashers were out in force at that time too. Most expected rates to rise on an improving economy. Even those that believed the economy was headed for disaster still believed rates would rise and that Bond ETFs would get killed; the Fed was irresponsible with respect to inflation, they argued, and the world would demand higher yields to own U.S. debt.

Yet the experts were wrong. Investment Grade Bond ETFs were the superstar stand-outs through the first 10 months of 2010. It follows that a contrarian thinker might consider iShares Investment Grade Corporate Bond (NYSEARCA:LQD). Whether owning it for the entire calendar year 2010 for an 8.8% unrealized profit or whether you realized your gains for 13% by selling at election time, very few experts predicted results like these for ‘10.

  1. Think Beyond Treasuries and Investment Grade

For some unknown reason, the bond market has been painted in black-n-white terms. If the overnight lending rate rises or if the 10-year Treasury note’s yield rises, it’s curtains for all income-producers. In reality, though, convertible bonds tend to track equities more than bonds, emerging market bonds tend to move based on emerging market rate cycles, and floating rate bonds often excel in a rising rate environment.

For example, the iShares 7-10 Year Treasury Bond Fund (NYSEARCA:IEF) lost roughly 6% from the day after the November election through December 30. On the other hand, SPDR Convertible Bond (NYSEARCA:CWB) gained nearly 3%. Granted, emerging market bonds haven’t done as well, but this may be more of a reaction to rate hikes from China to Brazil to Taiwan than anything else. I still like Powershares Emerging Market Sovereign Debt (NYSEARCA:PCY).

  1. What’s a Poor Investment in the First Place?

For example. If you invest in below-investment grade bonds via a diversified ETF like SPDR Capital High Yield Bond (NYSEARCA:JNK), you may start 2011 with an 8.5% annualized income delivered in monthly payouts. With a similar average maturity as the iShares 7-10 Year Treasury Bond Fund (IEF), SPDR Capital High Yield (JNK) might be expected to depreciate in price at a rate that maintains the current yield spread of 500 basis points. So… if IEF experiences a 2.5%-3.0% drop in price across the entire 12 months of 2011, the closing price of JNK might be 4%-4.5% lower.

But here’s the kicker! With rising yields and monthly payouts, the income stream might approach 9%. In other words, you could conceivably net 5% from SPDR Capital High Yield Bond, even if bond prices drop and interest rates rise. Granted, it’s not known if the yield spread will remain the same. And it’s not known if price movement will be too volatile for comfort. Nevertheless, the blanket assumption that bonds will be horrendous in 2011 fails to address bigger picture decisions for portfolio success.

Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.