“It’s very clear that the rate environment over the next 10 years will not look like the last 10,” says Leland Clemons, founder of ETF issuer BondBlox Investment Management.
If so, investors with portfolios that use bond funds for their fixed income allocation may try to use more targeted exchange-traded funds to recover those exposures.
twin risk
Bonds and bond funds primarily carry two types of risk. The first is credit risk, or the possibility that interest and principal will not be paid. This risk is usually expressed in the interest rate that investors are willing to accept. The better the credit, the lower the rate. S&P Global, Moody’s and Fitch assess debt issuance risk by assigning credit ratings from AAA/AAA (Stellar) to D (in default).
The second risk measure is known as duration, which indicates the sensitivity of a bond or bond portfolio to fluctuations in interest rates. Although measured in years, the term is not the same as maturity, or when the principal of a bond is paid off.
For bond funds and ETFs, the average duration or effective duration is usually included on the fund website or on a third-party site such as Morningstar or ETFs.com. Duration is useful for predicting how much the fund share price will move relative to changes in interest rates. A fund with a duration of 7 would be expected to decline 7% in response to a 1 percent increase in rates, or 7% in response to a 1 percent decrease in rates.
mission creep
To start a bond portfolio, John Kroc, head of fixed-income-product management active at Vanguard, suggests an investor with a fairly long time horizon—say, five to seven-plus years—invest in funds or ETFs. which tracks the AGG, or Bloomberg US Aggregate Bond Index.
“Out of the box, AGG gives you broad, diversified exposure to a liquid universe of US fixed income in US treasuries, investment-grade corporates and agency mortgages,” says Mr. Kroc.
Duration on AGG is currently approximately 6.5 years, while yields on index funds tracking the index range from approximately 4.2% to 4.4%.
However, most bond indexes are not stable and the level of risk can change depending on the market. “Indexing in fixed income can concentrate risk and push investors over the yield curve,” says Tim Courtney, chief investment officer at Accentual Wealth Advisors in Oklahoma City. The tendency of companies in recent years to load up on cheaper debt, for example, increased the duration and credit risk afforded by investment-grade corporate debt index funds. The period on the widely held $32 billion iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) increased to close to 10 in 2020 and 2021, while the fund’s credit profile declined. Its duration is currently 8.25, its yield is 5.9% and its expense ratio is 0.14%. According to Morningstar, shares of LQD are down 21.3% this year since November 1.
term maturity
A different type of bond-fund product, called a term or defined-maturity ETF, reduces interest-rate risk by offering investors the ability to build a bond-like ladder. Investors can ladder specific maturities of ETFs (from one to 10 years) that pay monthly income and return the same value at expiration, unlike traditional funds and ETFs that are permanent products.
Offered by BlackRock’s iShares unit as BulletShares by Invesco or iBonds, individual ETFs mature like traditional bonds and trade like U.S. Treasury, municipal bonds, investment-grade and high-yield corporate bonds, as well as emerging-markets. Invest in loans. Distributions are paid monthly, and par value is returned when the ETF “matures.” Depending on the availability of bonds in the asset class, investors can grow the ETF up to 10 years.
The capital gain (and loss) will depend on the price paid for ETF shares in the open market relative to the net asset value per share at maturity.
target period
Many index and actively managed funds have a target period for their portfolios, which rails at how much interest-rate risk the portfolio manager (or index) is willing to take. However, the duration can vary with the index the fund tracks or with the whims of the fund manager. In September, BondBlox launched eight target-duration ETFs for the US Treasury market. From six months to 20 years, these ETFs give investors the ability to shape their own yield curve with expense ratios ranging from 0.03% for six months to 0.125% for 20 years.
Separately, earlier this year, F/M Investments launched the U.S. Benchmark Series, which tracks only “on the run” or most recently issued U.S. Treasury securities at an expense ratio of 0.15% for three months, two years and 10 years. invests in. ,
“The duration should always be shorter than your time horizon,” says Michael Furla, head of fixed income for Mather Group, a financial advisory firm in Chicago.
On the smaller side, ETFs can also be used for cash management beyond the limited scope of money-market funds. In the wake of new Securities and Exchange Commission rules that restrict money-market-fund holdings, “ultrashort” bond ETFs like the $26 billion SPDR Bloomberg 1-3 Month T-Bill ETF (BIL) saw a wave of interest this year. Is. BIL alone has experienced $12.9 billion in net inflows as yields climbed up to 2.6%.
concentrated credit
Other ETF innovations have focused on more targeted credit risk, such as specific levels of credit quality or high-yield sectors. However, trying to predict profits in particular loan areas can be challenging. (Who could have predicted that Energy would perform better?)
Investing outside of America’s fixed income markets is [also] A great way to expand the diversification of a bond allocation beyond the US economy, given its single yield curve and single central bank. [the Fed]Vanguard’s Mr. Kroc says.
don’t overdo it
However, Mr. Kroc cautions that straying too far from the “ballast-ness” of strong fixed-income investing can undermine the diversification and stabilizing effect of fixed income on multi-asset portfolios.
“A bond allocation that ‘diversifies’ from high-quality bond sectors to high-yield and other low-quality sectors can really diversify your bond allocation on paper,” says Mr. Kroc. “However, it will also reduce its diversified impact on your equity allocation, resulting in an overall portfolio that is riskier than the one you started with.”
Mr. Courtney of Accentual reminds investors why they invest in bonds. “It’s first about liquidity and second about return above inflation,” he says. As for liquidity, bond funds and ETFs provide more liquidity than most bonds beyond the US Treasury. To cover inflation risk, bonds lagged behind inflation by about 33% of the annual period. (one to 20 years) Going back in 1926 from short-term to long-term treasuries as well as long-term corporate debt.
Mr. Kroc suggests checking allotments at least once a year “to determine if your circumstances have changed, have developed a tolerance for risk, or if the purpose of a given pool of assets and The deadline needs to be revised.”