Why Bonds and ETFs Are a Natural Fit

by: Tom Lydon

Investors are flocking to bonds of all types and the ETFs that hold them while they seek shelter from the storm that is the U.S. equity markets and get a little yield in the meantime.

Fixed income ETFs offer investors cheap, liquid and transparent exposure to the bond market. Dan Burrows for SmartMoney notes four types that are of particular interest these days:

  • High-grade corporate debt: Corporations are hungry for extra cash, and the environment is issuer-friendly right now; note the high exposure to financials in some funds.
  • High-yield corporate debt: The big yields are attractive for investors, but in a “bankruptcy watch” environment, this could be more risk that some investors might be able to stomach. We could see defaults in some corporations.
  • Treasury bonds and municipal bonds: Treasuries are considered the safest of bond types, while muni bonds have a higher risk of default. Stick to high-quality, general obligation bonds, where the default rate is generally lower.

Sophia Grene for The Financial Times reports that in 2008, global assets under management in fixed income ETFs almost doubled, jumping to $104 billion from $59.9 billion; the first months of 2009 added another $2.7 billion.

Because of the popularity of the fixed income ETF, there has been a trend toward many providers offering a range of these products. Barclays Global Investors has taken advantage of the enthusiasm and added five funds to its fixed income range. It has taken a longer time to build up the fixed income range of ETFs, mostly because of the lure of the equity heavyweights. The proportion will start to even out as time goes on, especially now that the equity stocks are in intensive care.

There is still work to be done on the bond indexes, as the main problem with fixed income ETFs is that bond indexes are not well constructed for the purpose. The index provider has to decide which best represents the value of the company’s debt.

So far in the United States, synthetic replication would take ETFs out of the regulated space, so broad indexes are usually replicated by sampling. An index might contain more than 20,000 bonds, but the ETF could track it holding just 120 issues.

  • Vanguard Total Bond Market (NYSEARCA:BND): down 3.9% year-to-date; yields 4.62%

  • iShares Barclays 1-3 Year Treasury Bond (NYSEARCA:SHY): down 0.9% year-to-date; yields 3.43%