Brocker.Org: ETFs Demystify Bond Market Exposure

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There are over 300 fixed income exchange traded funds (ETFs) trading in the U.S. and in most ETF markets, bond funds are only outpaced by equity ETFs in terms of size and popularity.

Bond ETFs can differ widely in strategy, from buying U.S. Treasuries to holding only high yield, from long-term focus to a short-term approach. The variety of bond ETFs is one of the asset class’s primary advantages. While investors have long had access to government bonds, municipal bonds and investment-grade corporate bonds, fixed income ETFs have opened previously hard-to-access corners of the bond universe to scores of investors.

Increased access to new bond venues is particularly useful at a time when many investors in developed markets, such as Canada and the U.S., are faced with the specter of low-yielding government debt. ETFs have made it easier for investors of all skill levels to access bonds ranging from high-yield corporate debt in the U.S. to junk-rated sovereigns and corporates in emerging markets.

Assets under management for U.S.-listed bond ETFs are approaching $500 billion on a combined basis, having more than doubled since 2010, according to Bloomberg data.

Just look at the iShares iBoxx $ High Yield Corporate Bond ETF (HYG). Prior to HYG coming to market over a decade ago, junk bonds were believed territory reserved exclusively for professional traders. Now home to over $18 billion in assets under management and one of the biggest bond ETFs in the U.S., HYG sports an interesting fact: About half its assets come from retail investors.

Last year, a BlackRock/Greenwich study indicated that increased regulations are making it harder for professional investors to transact in individual bonds, particularly away from the government bond markets. Nearly three-quarters of the respondents in that survey said those regulations are forcing them to alter how they invest and that is expected to result in increased inflows to bond ETFs.

“When asked why they invest in bond ETFs, 85 percent cite liquidity and 84 percent cite operational simplicity,” according to the study.

Recent trends in bond ETF flows show a dichotomy between investors’ need for income and a pensiveness about the Federal Reserve’s plans for U.S. borrowing costs. Through the first quarter of 2017, high-yield corporate bond ETFs in the U.S. garnered 9.2 percent of assets flowing into bond ETFs while emerging markets bond ETFs added 13 percent of bond ETF assets, according to Bloomberg. Treasury ETFs hauled in 5.7 percent of new assets for bond ETFs as of late March.

Here are some bond ETFs suitable for a wide range of investors and varying income needs.

Vanguard Total Bond Market ETF (BND)

The Vanguard Total Bond Market ETF stands as a solid option for investors seeking core exposure to U.S. investment-grade debt. BND is also a good idea for conservative investors seeking low-cost, liquid exposure to a vast lineup of high-grade bonds. BND holds 8,800 bonds, a number that few bond ETFs come close to competing with.

BND has an average duration of six years and the average effective maturity on the ETF’s holdings is 8.2 years. An issue with BND and other passively managed aggregate bond ETFs is that these funds usually allocate significant portions of their weight to U.S. government debt. BND does that to the tune of over 62 percent. While that diminishes credit risk, it also lowers the income potential investors are exposed to.

What that means is that investors, unless they are extremely risk-averse, should not rely entirely on aggregate bond funds for their income needs, particularly with U.S. rates still low. One perk of BND is that it charges just 0.06% a year, or less than 92% of competing funds.

SPDR Bloomberg Barclays Convertible Securities ETF (CWB)

The SPDR Bloomberg Barclays Convertible Securities ETF is a more adventurous fixed idea than an aggregate bond fund such as BND, but that does not diminish CWB’s potency or utility.

Convertible bonds are corporate bonds that can later be converted into equity in the issuing company. That gives CWB some equity-like traits, but the real advantage of this asset class is that convertibles are usually among the best-performing parts of the bond market as interest rates climb.

Convertibles have perks and drawbacks. For example, what investors lose in terms of interest rate risk (losing that is a good thing), they incur some credit risk with CWB as almost a third of the ETF’s roster is rated below Baa. Additionally, there is not much yield compensation for that credit risk as CWB’s 30-day SEC yield is below 2.6 percent. Still, history shows CWB often performs well when Treasury yields soar.

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