Long and Junk Bond ETFs: Stepchildren of Fixed Income Investing

by: Ray Hendon

Having gone through short, intermediate-term bond ETFs, and TIPS, it is now the turn of long term and junk ETFs. I will repeat my earlier prejudice about long term bonds—leave it to the institutional investors. Their volatility is too high to be appropriate for most individual investors. Plus, as you can see from Table 1 below, the investor is not rewarded in terms of dividend yield for taking on the increased volatility (click both tables to enlarge).

The ETFs listed in Table 1 are:

Table 1

Long-Term ETFs

You can see the popularity of pure Treasury holdings in long-term ETFs. Part of the reason is that institutional investors are the primary buyers of long-term obligations, and many of them are constrained by their own charters to stay with Treasuries. Another reason is that corporate bonds of this length are usually callable, which makes them unsuitable for many institutional portfolios, given the reinvestment risks a callable brings to the table, not to mention an unstable average duration.

Vanguard does not respect this tradition, as you can see from its holdings of about 50%/50% Treasury/Corporate. You can also observe the effects on its dividend yield; 5.39% is almost a full 100 basis points above the other ETFs. Given the age of this ETF (established 5/23/07) it has done well in attracting assets, already over half way to the $100 million mark. But, with an average duration of 11.3 you almost double the price fluctuations over that of Vanguard’s intermediate-term ETF. For me, this is not a tradeoff I would make, but every individual has his or her own preferences for risks.

One other point with respect to Vanguard: the large number of holdings is more necessary for their ETF, given that it mixes corporate bonds with Treasuries. Treasuries are consider safe enough not the have to worry about diversifying the risks. This is not true for corporate bonds, however. It would be a serious mistake for individual investors to hold a significant amount of their assets in one or two corporate issues. You take on too much business risks by doing this. And the only way to reduce the risk and still invest in corporate issues is to spread the risk over a large number of holdings. That is one of the features I discussed last time in intermediates. By owning the entire market, which the Lehman Aggregate Bond Index does ( more of less), you can have corporate issues in you holdings and still be properly diversified.

The ETF of PowerShares, PLW, is also interesting in its makeup. It emulates an advisor’s recommendation to ladder a bond portfolio. For an individual holder this means that you divide your bonds into, say, five categories. One-fifth in 1 year obligations, one-fifth in 2-year, and on out the ladder to one-fifth in 5 Year bonds. At the end of each year, you simply takes the money from the maturing one-year bonds and buy a new five-year. This keeps the duration about the same, year-over-year, and simplifies construction of your fixed income portfolio. It also has the advantage of keeping your bond portfolio current with respect to interest rates, so you are, more or less, indifferent to interest rate risks.

For individual investors this strategy does require a fairly hearty sum to implement, since buying bonds on the secondary market always incurs brokerage commissions so large as to preclude small ladders of, say, $10,000 --$2000 per rung of the ladder. Commission costs would simply be too much. The old rule of thumb for a ladder is about $100,000 at minimum. Now, with PowerShares, you can do it with an ETF.

This is an interesting innovation, and I am curious about how successful it will be. For now, it’s too early to tell, since this ETF was established in early October of last year.

The final category of bond ETFs I will cover today is one of great controversy. High yield, commonly referred to as Junk, has split the advisor community. Some advisors, whom I deeply respect, insist that junk holdings have equity-like risks (unstable average durations because of the risks of default) and therefore do not belong in the fixed income allocation of an individual investor. On the other hand, others whom I also respect, recommend a fairly high allocation of one’s fixed income holdings to this category. They think holding junk over a long time is ok, and the higher income produced by the spread is worth the volatility one gets with this class of bonds.

As for me, I fall back to one of the securest tenets of Modern Portfolio Theory, take only those risks you need to take and can afford to take. So, if your income needs require you to take a higher level of fixed income risks, and you can afford to volatility that comes with it, then take your chances. Overall I would prefer not to take the risks associated with high yield, unless the yield spread is enough to compensate for it. Often, this is not the case, in my view, but at times it may be, depending on your own needs and preferences.

Being warned, Table 2 covers the field of domestic high yield.

Here is the list of ETFs in Table 2:

Table 2: High Yield Bond ETFs

In this category of investment vehicles, mutual funds still have a substantial edge over ETFs on the number of offerings and a better cross section of quality. Oddly enough, among mutual funds, there are high variations of quality among the junk providers. Vanguard has what is considered the highest quality, and it falls off substantially from there.

Among the ETFs, all those in Table 2 began operation in 2007: iShares in April, SSgA November 28, and PowerShares November 15. None of them have a track record that gives us any historical perspective. They all hue to the middle of the yield curve, with SSgA and PowerShares being about a six months more venturesome. But, with the average duration of these instruments so volatile, you can’t count on them staying the same. With a default of two, average duration will change considerably.

I am sure all interested readers have noticed that I have omitted mention of municipal and international bond ETFs. This was planned. Munis have a unique market, and it is one that I have not studied sufficiently to warrant any comment. And there are only two states (California and New York) that have state-specific ETFs traded.

As far as international, I have used emerging market debt in the past as part of a bet I was willing to make against the dollar. But, for now, I think much of that play is over, so I’m staying clear of this field because of its extreme volatility. For me, taking on the extra political, currency and business risks of emerging markets must be rewarded with a substantial premium in yield. For the last few years this premium has not been high enough for my taste, so I don’t see it as a compelling alternative for now.

In terms of high quality international ETFs, there are some now appearing for sale in the U.S. But my take on international debt is that the costs of currency conversion and the higher cost of acquiring foreign debt with dollars, is high. This, to me, erases much if not all any short-term advantage foreign debt has over U.S. Treasury yields—when it does have an advantage. Also, with mutual funds, some international bond funds hedge the currency risk, and some don’t. To me, part of the reason to hold international obligations is for the currency risk exposure. So, if it is hedged away two things occur: you are left without exposure to a risk area that could add a healthy diversification to your portfolio, and you have to pay for the hedging, which further reduces the net yield.

I may be wrong on this issue, too. But, so far, I haven’t seen any evidence that convinces me that it is worth the expense and risk. The only exception I would make would be for those who are using un-hedged foreign bond ETFs or mutual funds to make a currency play. But, that introduces a level of speculation that many investors are uncomfortable with. If you want to play in those waters, good luck. There have been great fortunes made in this arena, and there have been great fortunes lost.

This concludes my comments on fixed income ETFs. I will return to the topic in the future for some additional information as this new part of the industry matures, and I plan on doing one article on suggestions about allocating fixed income holdings with ETFs. I hope you have found these discussions helpful in constructing your own fixed income portfolios.