Bloomberg News

A Boom in Bond Exchange-Traded Funds

April 17, 2012

Illustration by Dennis Pacheco

Illustration by Dennis Pacheco

Imagine having to choose among 1,450 different cars -- some wildly different, others subtly so. Checking them out would be fun, for the first hour or so. After two hours, it becomes a bore and after three, a royal pain in the neck. That's the way some financial advisers feel about all the options in the exchange-traded fund world today -- all 1,450 or so of them.

There's no relief in sight for those feeling overwhelmed, as a wave of new fixed-income ETFs reaches investors. Until recently, bond ETF pickings were pretty slim, but fund giants such as BlackRock are busy slicing and dicing fixed-income securities into tightly targeted offerings. Since 2009, the number of bond ETFs has risen from 52 to 191, and more wait in the wings.

“There’s a point where you suffer from analysis paralysis,” says Matt Terrien, a senior portfolio manager at Evanston Advisors in Schaumburg, Ill. “If I take my kids to the ice cream store and there’s 127 flavors, I spend a half an hour with them trying to figure out which one we want.”

Here's a sampling of the products being rolled out to allow investors to better diversify their exposure to bonds of certain industries, maturities and credit quality. While the offerings may help both fine-tune portfolios and spread risks, a crush of new financial offerings in the same area can be a contrarian indicator, so tread carefully.

Zeroing in

This February, BlackRock announced the first three sector bond ETFs -- IShares Utilities Sector Bond, IShares Industrials Sector Bond and IShares Financials Sector Bond. The three sectors make up almost all of the Barclays Capital U.S. Credit Bond Index, which tracks high-quality investment grade (debt rated BBB or better) corporate bonds. The industrial sector is a catchall that includes everything from telecom to technology and health care.

"There's been some concern by investors about the financial sector and corporate bonds issued by financial firms," says Matthew Tucker, head of the IShares fixed-income department. "Those investors can now buy the industrial IShares and the utilities IShares and create a diversified corporate bond portfolio without any financial exposure.” All three have yields of around 3 percent and expenses of 0.30 percent.

Keeping it short

Fears of inflation and rising interest rates are also a concern. Bond prices and interest rates have an inverse relationship -- and with rates close to zero, the only place to go is up. In response to such jitters, the fund industry has come out with several short-to-intermediate-term-maturity bond ETFs in the popular high-yield category.

Those products include the SPDR Barclays Capital Short Term High Yield Bond ETF and the PIMCO 0-5 Year High Yield Corporate Bond Index ETF. The PIMCO fund appeals to financial planner Theodore Feight, of Creative Financial Design. Feight, who has many retired clients, has been investing as much as 7 percent of client portfolios in the ETF. With an average bond maturity of 2.45 years, it's much less sensitive to rising rates than a long-term Treasury bond. Moreover, the ETF’s 4.93 percent yield exceeds the 30-year Treasury’s 3.35 percent.

"My clients need some bond income," says Feight. "However, I have told them that at the first sign of inflation, we may be selling any bonds we have.”

For investors really worried about inflation, the FlexShares bond ETFs track shorter-term inflation-protected securities (TIPS). “We approach every portfolio from a risk perspective first,” says Michael McClary, chief investment officer of ValMark Advisers, an institutional asset manager of $2 billion. Risk for McClary, in fixed-income, is a portfolio's "duration." Duration is a wonky term that signifies how sensitive a bond's value is to moves in interest rates. If a bond fund's duration is 1.5 years, it means the fund will decrease about 1.5% in value if interest rates rise 1%, and it will increase 1.5% if rates fall by the same amount.

McClary is moving a third of his clients' TIPS positions into the FlexShares ETFs, which have durations ranging from three years to five years. He's keeping some exposure to the IShares Barclays TIPS Bond ETF, which tracks bonds of all maturities. “With that position, the difference is it can move on you pretty quickly because it’s more rate-sensitive," he says. "With the target-duration ETF, we pretty much know where it’s going to be.”

Climbing the ladder

Some investors want to control exactly when their bonds will mature. Precision is necessary for those who build "laddered" portfolios of bonds that mature at different dates, when the investor will need capital for such purposes as college tuition.

Since June 2010, Guggenheim Investments has launched a slew of BulletShares corporate bond ETFs with specific maturity dates. The three offered this March will mature in 2018, 2019 and 2020, and they invest in a diversified basket of high-quality corporate bonds. When the bonds mature, shareholders’ capital is returned.

The ETFs are helpful because most investors don’t have enough money to build a diversified laddered portfolio. “When I put together bond ladders, I generally have to stick to one or two bonds in any one maturity unless they have a significant amount of money,” says Peter Regan, a financial planner with CEP Financial in Houston. “So I find that I always have to stick with very high credit qualities to avoid defaults."

With ETFs such as the BulletShares, "you can buy a basket of bonds with a lower credit quality -- like A -- and because they hold hundreds of bonds, you don’t have to worry so much if one defaults," says Regan. "You get a little extra yield because the credit quality for the ETF portfolio is A, instead of AAA for the bonds you would’ve purchased on your own.”

One worry: The ETFs tend be concentrated in industries raising capital in the debt markets at the same time. So, for instance, the Guggenheim BulletShares 2015 Corporate Bond ETF has a 60 percent weighting in financials because banks have been raising a lot of money in recent years.

Credit check

Although the economy seems to have improved, many investors are still skittish about the credit quality of their bond portfolio. To cater to this concern in February,  BlackRock launched the IShares Aaa - A Rated Corporate Bond ETF. (Van Eck is taking a different tack, offering a Market Vectors Fallen Angel Bond ETF that focuses on securities that were initially rated investment-grade but were downgraded to junk status.)

A more interesting credit play is the Powershares Fundamental Investment Grade Corporate Bond ETF that came out last September. The index to this ETF was designed by Research Affiliates and its founder, Rob Arnott. The index accords the heaviest weights to bonds of issuers with the greatest financial strength -- those with the highest cash flow, dividends, sales and book value.

That strategy differs from most bond ETFs, which follow market-cap-weighted indexes that invest the most in those issuers with the greatest amount of outstanding debt. That can result in an index heavily weighted in the most overleveraged companies.

Floating Rates

For those nervous about both credit quality and interest rates, there are two new floating-rate bond ETFs -- SPDR Barclays Cap Investment Grade Floating Rate ETF and IShares Floating Rate Note. These bonds don’t pay fixed interest rates but have yields that reset periodically, so if rates are rising, the bonds’ payouts rise with them.

The ETFs are unusual in that they buy high-quality bonds instead of junk-rated bank loans with floating rates. The latter are a common investment available in some 40 bank-loan mutual funds, paying higher yields but assuming more credit risk. So for true worrywarts, these ETFs could be preferable. Yields for them are low, though, at 1.3 percent. As with everything in investing, it’s tough to have your cake and eat it, too.

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