4 Reasons Investors Shouldn't Rely on Fixed Income ETFs

by: Michael Johnston

As the ETF industry has expanded in recent years, a significant percentage of the expansion has come from equity ETFs embracing new regions and investment styles and from commodity funds offering small investors exposure to resources that were previously available only to the ultra-rich (although position limits are threatening to restrict access to numerous commodity funds). Despite the importance of fixed income instruments in investor portfolios (as proven by their performance relative to stocks during the recent downturn), fixed income ETFs lag behind their equity counterparts in terms of number of funds. According to our ETF Database, there are currently about 70 fixed income ETFs, compared to more than 600 equity funds.

As worries about the ability of fixed income investments to perform inside of an exchange-traded structure have been shown to be unfounded, we are beginning to see an increase in bond ETF activity. According to State Street’s July ETF snapshot, 10 new funds have been launched this year, and fixed income ETFs have seen assets grow by almost $26 billion.

AGG Is A Good Place To Start, But It ShouldnTwo of the most popular fixed income ETFs are the iShares Barclays Aggregate Bond Fund (NYSEARCA:AGG) and the Vanguard Total Bond Market ETF (NYSEARCA:BND). These “total bond market” ETFs offer diversified exposure to the U.S. bond markets, prompting many investors to achieve a significant portion of their fixed income investments to a single ETF.

But while AGG and BND are well-diversified, very liquid, and cost-efficient, gaining your fixed income exposure exclusively through one of these “one stop shop” ETFs is a very common investing mistake. Don’t get me wrong – AGG and BND are excellent products (I recently upped my stake in AGG) – but they aren’t the last word in fixed income investing. Here are four reasons why investors should avoid relying too heavily on one of these fixed income ETFs:

1. Significant Allocation to Treasuries and Government-Sponsored Securities: According to its most recent fact sheet, AGG allocates more than a quarter of its holdings to U.S. Treasuries, and nearly 50% to securities issued by FNMA, GNMA, FHLMC, and other U.S. government-sponsored agencies. If investors are particularly bullish on Treasuries, AGG offers a significant amount of exposure. But many investors would be better served to hold a higher percentage of their fixed income portfolio in corporate bonds and other fixed income instruments with higher yields.

2. No Exposure to High Yield Bonds: AGG and BND offer exposure to the total investment grade U.S. bond market, meaning that they invest primarily in debt issues that are above a certain rating (BBB- by Standard & Poor’s and Baa3 by Moody’s). Bonds rated below these cutoffs (also known as “speculative” or “junk” bonds) carry a higher risk of default, and as such generally offer a higher rate of return. If upgraded to investment grade status, high yield bonds can see a narrowing of their credit spread and a jump in price. There are several high yield bond ETFs available, including:

  • SPDR Barclays High Yield Bond ETF (NYSEARCA:JNK)
  • PowerShares High Yield Corporate Bond Portfolio (NYSE:PHB)
  • iShares iBoxx $ High Yield Corporate Bond Fund (NYSEARCA:HYG)

3. Shortage of Inflation-Protected Securities: Inflation-protected securities have become increasingly popular among investors in recent months, as concerns over inflation resulting from the massive stimulus plans have ramped up. Total bond market ETFs have limited holdings in inflation-protected securities, indicating that the real returns on these securities may be negatively impacted if we experience a significant uptick in inflation (as many analysts fear we may). Although inflation-protected securities have some limitations (such as alleged under-reporting of CPI figures), they should be a component of any investor’s portfolio. ETFs offering exposure to inflation-protected bonds include:

  • iShares Barclays TIPS Fund (NYSEARCA:TIP): Maintains a market capitalization of more than $15 billion.
  • SPDR DB International Government Inflation-Protected Bond ETF (NYSEARCA:WIP): Holds inflation-protected bonds issued by foreign governments.
  • SPDR Barclays Capital TIPS ETF (NYSEARCA:IPE): Maintains an expense ratio of only 0.18%.
  • Pimco 1-5 Year U.S. TIPS Index Fund (NYSEARCA:STPZ): The second ETF offering from Pimco, STPZ offers exposure to low duration TIPS.

4. Light on the “Exotic” Fixed Income Offerings: When most investors think of bonds, Treasuries and corporate bonds are generally the first instruments that come to mind. But the universe of bond investments hardly stops there. Municipal bonds, emerging market bonds, and convertible bonds are but a few of the less traditional fixed income instruments that may deserve consideration from some investors (for more information, check out our guide to fixed income ETF investing).

Part Of The Answer

In my opinion, total bond market ETFs such as AGG and BND should account for a major portion of every investor’s portfolio. But they shouldn’t represent the entirety of fixed income exposure. One-stop shopping for your bond fill, while convenient and cost-efficient, isn’t practical for most investors looking to tailor their portfolio to their specific circumstances.

Jimmy Atkinson contributed to this article.

Disclosure: Long AGG, JNK.