Fixed Income - Now Is Not The Time

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Includes: LQD, PLW, SCHP, TIPS
by: Simply Investing

Summary

I recently reviewed the Seeking Alpha ETF Investing Guide and decided to implement it for a portion of my portfolio.

This article reviews the three fixed income ETFs in the core portfolio of Seeking Alpha’s ETF Investing Guide.

The three fixed-income ETFs recommended may be suitable for some investors, but until interest rates increase, I will keep the fixed income portion of my portfolio in short-term bank cd’s.

The Seeking Alpha ETF Investing Guide

I recently reviewed the Seeking Alpha Investing Guide and decided to allocate part of my portfolio to a core portfolio of ETFs, similar to that suggested by the guide. I do not intend to completely switch course from my current allocation but to set up a separate core portfolio of ETFs and to allocate a majority of my investments to this Core ETF portfolio over time.

After reviewing the investing guide, I drafted a procedure for implementing the suggestions of the guide. Currently, I am reviewing each of the suggested ETFs to determine which to buy. Readers that have read the articles on the first five recommended ETFs are aware that I plan to invest in the sectors that they represent. This article focuses on the three recommended ETFs from the fixed income portion of the Core ETF portfolio:

  • iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA:LQD)
  • PowerShares 1-30 Laddered Treasury Portfolio ETF (NASDAQ:PLW)
  • Schwab U.S. TIPS ETF (NYSEARCA:SCHP)

At this point, I am not inclined to invest in these ETFs, or the fixed income sectors these represent. I expect to keep funds I have allocated for this portion of my portfolio, invested in shorter-term bank certificates of deposit (cd's) that offer similar interest rates with what I believe is far less risk of capital loss.

Investment synopsis of the three fixed income funds

The iShares iBoxx $ Investment Grade Corporate Bond ETF seeks to track the investment results of an index composed of U.S. dollar-denominated, investment grade corporate bonds. LQD provides exposure to a broad range of over 1000 U.S. investment grade corporate bonds. LQD can be used by investors seeking stability and income.

The PowerShares 1-30 Laddered Treasury Portfolio is based on the Ryan/NASDAQ U.S. 1-30 Year Treasury Laddered Index. The Fund will normally invest at least 90% of its total assets in securities that comprise the Index. The Index measures the potential returns of the U.S. Treasury yield curve based on approximately 30 equally weighted U.S. Treasury issues with fixed coupons, scheduled to mature in a proportional, annual sequential ("laddered") structure.

The Schwab U.S. TIPS ETF goal is to track as closely as possible, before fees and expenses, the price and yield performance of the Barclays U.S. Treasury Inflation Protected Securities ((OTC:TIPS)) Index (Series L). SCHP provides a convenient, low-cost way to capture the performance of U.S. Treasury Inflation Protected Securities. SCHP provides exposure to a portfolio of treasury securities designed to offer protection from the negative impact of inflation while assuming exposure to interest rate risk.

US treasury 10 year interest rate chart - 1962 to present

Click to enlarge

Source: Yahoo Finance (2/13/2016)

The chart above shows US treasury 10 year interest rates since 1962. After peaking in 1981, interest rates have fallen steadily to their current rate of 1.75%. Interest rates were slightly lower for a short period in 2012 but other than that, they are at the lowest point over the 50 plus years shown. While I have felt the same way for some time, as interest rates have continued to fall, I would not be comfortable investing in medium or long-term bonds at current interest rates. In the past, I have found that when I make investments that I am not comfortable with, I have a very hard time holding them.

Performance of LQD, PLW and SCHP compared to the S&P 500 since June 2002

Click to enlarge

Source: Yahoo Finance (2/13/2016)

The chart above shows the performance of the three fixed income ETFs versus the S&P 500. LQD had the longest history going back to 2002 and over this time is up 11% versus the S&P up 103%. The chart does not include interest or dividends, which would improve the relative performance of the fixed income ETFs versus the S&P 500.

Performance of LQD, PLW and SCHP compared to the S&P 500 - 5 year chart

Click to enlarge

Source: Yahoo Finance (2/13/2016)

The chart above shows the performance of the three fixed income ETFs versus the S&P 500 over the last five years. Again the S&P 500 has outperformed the 3 fixed income ETFs and again this chart does not include interest or dividends, which would improve the relative performance of the fixed income ETFs versus the S&P 500.

ETFs in the US corporate bond category

ETFs in the US treasury bond broad duration category

ETFs in the US treasury inflation protected category

Source: Seeking Alpha (as of 2/13/2016)

Above are lists of the top 10 fixed income ETFs in each of the categories represented by the three recommended ETFs. Each category is listed by assets under management (AUM). As the tables show, there are a number of alternatives that interested investors can consider in each category, except the "treasury bond broad duration" category which only lists 2 ETFs on Seeking Alpha's ETF Hub.

Fund characteristics

iShares iBoxx $ Investment Grade Corporate Bond ETF

PowerShares 1-30 Laddered Treasury Portfolio ETF

Schwab U.S. TIPS ETF

Weighted average duration (years)

7.98

10.34

7.5

Weighted average maturity (years)

12.28

15.84

8.3

SEC yield (%)

3.73

2.49

0.02

Expense ratio (%)

0.15

0.25

0.07

Click to enlarge

Source: iShares by BlackRock, Powershares and Schwab (as of 12/31/2015)

The fund characteristics are shown in the table above. I consider these characteristics versus a bank certificate of deposit (cd). Bankrate.com currently shows a one year cd at 1.30% and a five year cd at 2.27%. I do not feel that the potential yield improvement justifies the additional risk associated with the additional time to maturity, duration and the default risk of the corporate bonds. Other investors may be in a different position and see this differently.

Conclusion

Readers that have read the articles reviewing the first five recommended ETFs from Seeking Alpha's ETF Investment Guide are aware that I plan to invest in the sectors that these ETFs represent, either in the recommended ETF or a very similar ETF. I do not feel the same way about the recommended fixed income ETFs, iShares iBoxx $ Investment Grade Corporate Bond ETF, PowerShares 1-30 Laddered Treasury Portfolio ETF and Schwab U.S. TIPS ETF.

After peaking in 1981, US ten year treasury bond interest rates have fallen steadily to their current rate of 1.75%. Although others may feel differently, I would not be comfortable investing in ETFs made up of medium or long-term bonds at current interest rates. In the past, I have found that when I make investments that I am not comfortable with, I have a very hard time holding them.

At this point, I am not inclined to invest in the three recommended fixed income sectors or ETFs:

  • iShares iBoxx $ Investment Grade Corporate Bond ETF
  • PowerShares 1-30 Laddered Treasury Portfolio ETF
  • Schwab U.S. TIPS ETF

I expect to keep funds I have allocated for this portion of my core ETF portfolio, invested in shorter-term bank certificates of deposit (cd's) that offer similar interest rates with what I believe is far less risk of capital loss. I expect to review this periodically and consider investing in these ETFs and sectors when long-term interest rates have increased from current levels.

Addendum

Seeking Alpha's Investment Guide Core ETF Portfolio

ETF Ticker

Fund Name

Fund Description

Expense Ratio

VOO

Vanguard S&P 500 ETF

Large cap US stocks

0.05%

IJH

iShares Core S&P Mid Cap ETF

Mid cap US stocks

0.12%

VTWO

Vanguard Russell 2000 ETF

Small cap US stocks

0.15%

IEFA

iShares Core MSCI EAFE ETF

Multi cap foreign developed market stocks

0.12%

IEMG

iShares Core MSCI Emerging Markets ETF

Multi cap emerging market stocks

0.18%

LQD

iShares iBoxx $ Investment Grade Corporate Bond ETF

US investment grade corporate bonds

0.15%

PLW

PowerShares 1-30 Laddered Treasury Portfolio ETF

US Treasuries

0.25%

SCHP

Schwab U.S. TIPS ETF

US TIPS

0.07%

VNQ

Vanguard REIT Index ETF

US REITs

0.10%

DBC

PowerShares DB Commodity Index Tracking ETF

Broad commodities

0.85%

Click to enlarge

Simply Investing - Philosophy

Establishing a core portfolio in well-diversified, low expense ETFs, held for the long term, is a good idea for most all investors. The core of a small portfolio can start off as simple as one well diversified global ETF with a low expense ratio, like Vanguard Total World Stock ETF (NYSEARCA:VT). Typically, as the portfolio grows, the core of the portfolio would include exposure to the ten asset classes listed above.

There are four steps needed to set up an efficient investment plan. The decisions and actions required to set up the plan and purchase the ETFs can be done in about 4 hours (see the further reading section below for more details):

  1. Decide on an asset allocation plan among the ETFs in the core portfolio.
  2. Open an online brokerage account with a linked online bank account.
  3. Determine if you will invest all your investment funds at once or over a period of time.
  4. Determine which investments to buy in your taxable and tax deferred accounts.

The core ETF portfolio outlined above, after tax, should significantly outperform either individual stock picking or a portfolio managed by a financial advisor. Over the typical investors time horizon of 40+ years, the expected advantage of this core ETF portfolio is staggering.

Investors that enjoy the investment analysis process and are willing to spend the time to analyze and invest in individual stocks or sectors can still do this. I believe, the majority of these investors should still set up a core ETF portfolio, but can allocate a small, fixed percentage of their portfolio to "edge" positions, which offer additional risk and opportunity.

Further reading

ETF Investing Guide - Written by Seeking Alpha's Founder in 2006 is a great guide for setting up a portfolio of ETFs.

Set Up A Core ETF Portfolio Now - Describes the four steps required to implement the suggestions in the ETF Investing Guide. The ETF Investing Guide is made up of 54 articles and takes some time to read and assimilate the information. This article condenses the information from the guide down to four steps that can be completed to set up a core ETF portfolio in around four hours.

Disclosure: I am/we are long VT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.