Interest in achieving fixed income exposure through exchange-traded funds has been a hot topic in recent years, with some advisors expressing serious concerns over the potential shortcomings in bond ETFs while others have fully embraced the efficiencies of the exchange-traded structure.
The sheer size of the bond ETF space–in terms of both AUM and number of products–has increased dramatically since 2005. But the activity in the space has not been limited to pure growth in assets; a number of interesting innovations in the fixed income ETF arena have helped to address many of the issues that have been cited as potential concerns to investors and to enhance the overall experience of these products. Bond ETFs still aren’t perfect; many of the more popular products that are difficult to replicate exactly, exhibit certain biases that may be undesirable in certain environments and can create for recurring “front-running” opportunities that can erode returns. But the developments in the last several years have left advisors with a much more powerful and efficient set of tools for achieving fixed income exposure.
Here’s a quick look at some of the more meaningful innovations in recent years that can help investors get the most out of bond ETFs:
International Bond ETFs: Australia, Brazil, China, And More
U.S.-based investors long ago embraced geographic diversification within equity portfolios as a source of return enhancement and risk reduction, and they have gradually increased weightings to international stocks in recent years as the discrepancy in return potential has become increasingly significant. But that same attitude has yet to make its way to bonds; most U.S. portfolios are severely lacking in terms of international fixed income exposure, a condition that is puzzling in the current environment. With a mounting debt burden and record low rates, it isn’t difficult to argue that certain international debt markets offer both higher yields and lower risk exposure.
Just as ETFs gradually opened up to include stock markets in just about every major global economy in the early 2000s, there are now a record number of international fixed income products. And the selection is no longer limited to broad-based funds consisting of Treasuries of developed market governments; the current lineup of tools features options for precise exposure to bonds from various regions, credit qualities, and durations. At present, the lineup includes:
- Emerging Markets (Local Currency) (ELD)
- Emerging Markets (U.S. Dollar-Denominated) (EMB)
- Asia (ALD)
- Latin America (BONO)
- Australia (AUD)
- Australia / New Zealand (AUNZ)
- Germany (BUNL)
- Italy (ITLY)
- China (CHLC, RMB, DSUM)
- Developed Market Corporate Bonds (IBND, PICB)
- Inflation-Protected Bonds (WIP)
The ETFs and ETNs highlighted above allow investors to construct a broad-based, balanced bond portfolio with all the inherent benefits of the exchange-traded structure.
Target Maturity Date: Bond ETFs That Act Like Bonds
Traditional bond ETFs track a constant maturity index that rolls over bond holdings based on a minimum maturity rule which moves out of bond holdings once their maturity reaches a certain point. While this has been the dominant for fixed income ETF exposure, these products do not behave like a traditional bond holding that distributes steady cash streams until maturity. So why is this an issue? Let’s say an investor needed his or her money in five years time and invested in a constant maturity bond fund. By the time the five years comes around, the fund has rolled into intermediate term exposure which means the investor “is at risk of experiencing a significant capital loss if interest rates rise before he liquidates his investment” according to Matthew Patterson, Head of Investment Strategy at Accretive Asset Management LLC. But there are now options in the exchange-traded world that will behave more like an individual debt as they are attached to target maturity dates.
Target maturity bonds all track a separate index that matures on a known future year. This strategy allows for investors and financial advisors alike to accurately predict cash flows as well simply knowing when their bonds will mature. An investment in a target maturity product will ensure that liabilities decrease as the target date draws near while still providing the diversification benefits of fixed income exposure. There are now target date bonds for all kinds of investors, whether you want a maturity for next year, or several years down the line. Below we outline several target maturity funds:
- BulletShares 2011 Corporate Bond ETF (BSCB)
- BulletShares 2012 Corporate Bond ETF (BSCC)
- BulletShares 2013 Corporate Bond ETF (BSCD)
- BulletShares 2014 Corporate Bond ETF (BSCE)
- BulletShares 2015 Corporate Bond ETF (BSCF)
- BulletShares 2016 Corporate Bond ETF (BSCG)
- BulletShares 2017 Corporate Bond ETF (BSCH)
Fundamental Weighting: Now In Fixed Income Wrapper
Market cap weighting has long been the traditional strategy for not only ETFs, but almost all basket funds. But as the ETF industry expanded, many have realized the benefits of alternative weighting strategies as a number of them outdid their cap-weighted counterparts. More recently these strategies have waded into fixed income territory and yielded several interesting bond ETF products:
- SPDR Barclays Capital Issuer Scored Corporate Bond ETF (CBND) - This ETF uses three fundamental factors to determine the weight given to each debt it holds: return on assets, interest coverage, and current ratio.
- Fundamental High Yield Corporate Bond Portfolio (PHB) - This product uses the RAFI approach to selecting its holdings using four factors: book value of assets, gross sales, gross dividends, and cash flow–each based on five-year averages. Note that PHB is classified in the high yield or “junk bond” category.
- Fundamental Investment Grade Corporate Bond (PFIG) - PFIG also uses the RAFI weighting methodology, but instead applies it to investment grade corporate bonds.
Disclosure: No positions at time of writing.
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