Innovation in the bond ETF space in recent years has been truly impressive, resulting in the introduction of a number of products that allow investors to fine tune their fixed income exposure. While the most popular bond ETFs are those that offer broad-based exposure to a variety of issuers and maturities (such as AGG or BND), there are dozens of more targeted products that allow investors to focus in on specific risk factors while avoiding others altogether.
In the world of bond investing, the primary risk factors relate to the creditworthiness of the issuer and the duration of the fund. The concept of credit risk is fairly straightforward: the less likely an issuer is to repay its obligations, the higher yield investors will demand. While interest rates have little direct impact on the probability of default, they can have a significant impact on the demand (and therefor the market price) of existing fixed income securities. When rates rise, existing debt loses a bit of its luster since investors can purchase new debt with a more attractive cash flow profile [also see ETFs For The Forgotten Asset Classes].
The last few years have been an interesting stretch for bond investors. The Fed dropped its benchmark interest rate several times in 2008, finally slashing the Fed funds rate to a range of zero to 0.25% in December of that year. Rates have remained depressed ever since in an attempt to nurse a fragile recovery, prompting some investors to dial up risk exposure in order to generate more attractive current returns. But many have been wary of an eventual rate hike that could pummel long-dated securities and fixed income portfolios with considerable interest rate risk.
There are no signs that an interest rate hike is imminent. Recently, the January 2012 fed funds futures contract implied traders are pricing in about a 24% chance the U.S. central bank will raise rates to 0.50% from 0.25% after its December policy meeting. This percentage has declined considerably in recent weeks; it compares with a 92% chance of such an increase in mid-February. On the other hand, the broad-based rally in commodity markets that has played out over the last several months seeming indicates that inflationary pressures are accelerating. Interest rates can’t go much lower, and sooner or later a rate hike campaign will commence [Bond ETFs: 12 Stops Along The Risk/Return Spectrum].
There are, of course, ultra-low risk ETF options that invest in securities with both low durations and low credit risk. The SPDR Barclays 1-3 Month T-Bill ETF (BIL), for example, invests in short-term debt of the U.S. government. The iShares Barclays Short Treasury Fund (SHV) is cut from a similar cloth, investing in short-term debt from high quality issuers (generally the U.S. government, or agencies backed by the full faith and credit of Uncle Sam). But because these funds are light on both interest rate risk and credit risk, they are also light on expected return. BIL recently exhibited a 30-day SEC yield of 0.01%, while the same metric for SHV came in at a whopping nine basis points. Talk about anemic yields.
Beyond short-dated Treasuries, there are a number of options that tilt away from interest rate risk, but still offer exposure to the credit risk that accompanies more attractive yield profiles. Below, we profile four options for investors looking to capture current returns but looking to avoid securities that will get hammered once rates start climbing higher.
PowerShares Senior Loan Fund (BKLN)
The recently launched BKLN is unique in that the underlying securities are floating rate debt, meaning that the effective interest rates are determined relative to a reference rate and reset on a regular basis. As such the impact of interest rate hikes will be minimal. But because senior loans are often issued to companies with credit ratings below investment grade in connection with leveraged buyouts or other acquisition activities, this debt fund exposes investors to some credit risk. And with that credit risk comes a fairly attractive yield; BKLN recently had a yield to maturity in the neighborhood of 5%.
BKLN isn’t risk free, but it provides an opportunity for investors to diversify the risk profile of their bond holdings and potentially trim back interest rate risk without sacrificing expected return [see Under The Hood Of The Bank Loan ETF].
Vanguard Short Term Corporate Debt ETF (VCSH)
This ETF offers exposure to investment grade corporate debt, meaning that the credit risk of the underlying securities will generally be less than a junk bond fund. Almost all of the debt held by VCSH is rated between Baa and Aa, and the issuers represented include well known large cap companies such as General Electric and Wells Fargo.
Unlike BKLN, the debt held by VCSH is primarily fixed rate, but interest rate risk is curtailed because the underlying holdings are generally within five years of maturity. VCSH has an average duration of 2.8 years; by comparison, the same metric for VCLT comes in at more than 12 years. As such the yield offered by VCSH is considerably lower than its long-term counterpart, but may be attractive relative to funds that invest in Treasuries. VCSH has a 30-day SEC yield of about 2.1%–quite a bit higher than the same metric for a fund like the Barclays 1-3 Year Treasury Bond Fund (the 30-day SEC yield for SHY is 0.6%).
Most fixed income ETFs offer investors a "yield experience" that differs considerably from holding individual bonds. Whereas the cash flow profile of bonds includes return of principal upon maturity, the majority of fixed income ETFs on the market don’t hold bonds to maturity. When underlying holdings move out of the "eligibility window" they are sold by the fund and the proceeds used to purchase new securities that have now meet qualifications for inclusion in the underlying index.
Guggenheim has pioneered a different type of bond ETF that more closely replicates the cash flow profile of individual bonds, holding securities until maturity and subsequently distributing the proceeds to investors. Most fixed income ETFs will continue to operate into perpetuity, but those in the BulletShares suite have a known end date. There are a number of potential advantages of this structure, including an opportunity to reduce tracking error and return lags caused by portfolio turnover and adverse impacts of front-running. But the BulletShares structure also allows investors to fine tune their interest rate risk; whereas most bond ETFs cover a range of maturities (e.g., the Barclays 7-10 Year Treasury Bond Fund), each of the BulletShares targets debt securities scheduled to mature in a single year. For those seeking to minimize interest rate risk but willing to take on some credit risk, there are options at the short end of the maturity curve that may be intriguing [see Beyond LQD: Exploring Corporate Bond ETF Options]:
- 2011 Corporate Bond ETF (BSCB):The index underlying this ETF has a weighted average modified duration of 0.4 years and a weighted average yield to maturity of 1.1%.
- 2012 Corporate Bond ETF (BSCC): The index underlying this ETF has a weighted average modified duration of 1.3 years and a weighted average yield to maturity of 1.3%.
- 2012 Corporate Bond ETF (BSCD): The index underlying this ETF has a weighted average modified duration of 2.1 years and a weighted average yield to maturity of 2.3%.
For investors looking to take on a little more in the way of credit risk in return for a higher expected return, Guggenheim also offers a suite of ETFs focusing on junk bonds maturing in a specific year. The underlying holdings of these funds are generally rated BB or below, and the issuers can include cash-strapped companies whose ability to repay their debts is uncertain. As a result, the yields offered can be pretty juicy considering the scarcity of interest rate risk included:
- 2012 High Yield Corporate Bond ETF (BSJC): The index underlying this ETF has a weighted average duration to worst of 1.1 years and a weighted average yield to maturity of 5.8%.
- 2013 High Yield Corporate Bond ETF (BSJD): The index underlying this ETF has a weighted average duration to worst of 1.8 years and a weighted average yield to maturity of 6.3%.
Disclosure: No positions at time of writing.
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