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Portfolio > Mutual Funds > Bond Funds

Part: 2:Managing Bonds Better

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The introduction of fixed-income exchange traded funds gives advisors a better way to manage diversified portfolios that include bonds.

ETFs are index funds that are bought and sold like stocks on national exchanges. They hold baskets of securities that allow investors to diversify broadly by paying one transaction fee and a management fee that is as low as that levied by the lowest-cost mutual fund holding a similar portfolio. Barclays Global Investors (BGI) was already popular with advisors because of its series of 66 passively managed iShares equity index funds. On July 26, Barclays launched four new fixed-income ETFs, including a corporate bond fund. It’s the first fixed-income ETF ever, and it offers strong benefits to advisors.

The bond market is a dealer market dominated by huge institutional investors, which makes it a lot more work for an advisor to buy a bond than a stock. Since advisors need smaller bond purchases and more sales support than institutional investors, the independent advisor market is not served by the biggest bond dealers, and getting good prices and service can be difficult.

NASD rules permit a bond dealer to mark up the price on a bond by as much as 5%, which means advisors usually have to call around to several dealers to get the best quotes when buying or selling a bond. That’s far more difficult than checking a stock price on an exchange.

“Right now, we’re in a market with the three-year bond yield at about 3%, and a 5% markup means you give up 2 1/2 years of interest,” explains Lee Kranefuss, CEO of the individual investor ETF business at BGI. All of the bond desks you call might mark up a bond by that much or some could be cheaper, but you have to do the research to ensure you get the best pricing. “In contrast, with the bond ETF, the fair value of the portfolio crosses the ticker every 15 seconds.”

Kranefuss says the fair market value or net asset value of the bond ETFs is available online and based on institutional prices for the underlying portfolios, so that you can see how closely the price of the ETF is trading to the NAV. “This is one of the few instance where an advisor can access the same product and pricing as a large pension fund, hedge fund, or mutual fund,” he says.

Advisors who do manage portfolios of individual bonds sometimes find that doing the shopping for the bonds and getting ownership is a good bit of work. If you have laddered portfolios, you can be constantly cycling through the oldest issues and seeking replacements. With a fixed-income ETF, that work is done for you.

The nicest thing about ETFs, however, is that they carry low expenses. The iShares all have expense ratios of 15 basis points. That’s about 90 basis points to 100 basis points lower than the average fixed income fund’s expense ratio. For instance, the average intermediate-term government bond fund expense ratio is 116 basis points, according to recent data from Morningstar Inc., while the seven- to 10-year iShares trust is 15 basis points. Even the low-cost Vanguard intermediate term bond fund costs more than the similar-term ETF–albeit just six basis points more.

But the ETF has some other advantages, Kranefuss says. Bond mutual funds need to make trades to make redemptions sometimes.

Though the fixed income iShares are only a few weeks old, they already are drawing competition. ETF Advisors in New York has filed plans with the Securities and Exchange Commission to offer four fixed-income ETFs that are different in an important way. The iShares are pegged against the well-known Lehman Brothers bond indexes, which were created to be bond benchmarks and not as investable indexes. ETF Advisors plans to roll out bond ETFs that are pegged against “on-the-run” U.S. Treasury securities. They use the Ryan Holdings series of Treasury FITRs indexes that comprise the most recently auctioned government bonds. (FITRs stands for Fixed Income Treasury Receipts.)

About 80% of the volume in the U.S. Treasury bond market is in the most recently auctioned issues. That’s where spreads are tightest and liquidity is greatest. Since the iShares trusts are pegged against the Lehman indexes and include many bonds that were auctioned years ago, the bonds it holds tend to be traded less and could have wider spreads. That’s less desirable in an ETF since it’s meant to be an efficient vehicle to pass through the underlying characteristics of the bonds it holds. Whether the differential provided by ETF Advisors’ FITRS will be enough to compete with the better-known Lehman indexes and Barclays Global brand names remains to be seen, but the FITRs ETFs could offer some unique benefits.

For instance, the one-year FITR or two-year FITR ETF could be used as a money fund replacement, and allow an advisor to earn a fee on a client’s cash position. In mid-September, the one-year FITR was yielding about 1.75% and the two-year FITR about 2.04%. After ETF Advisors get its 15-basis-point expense ratio, that’s 1.6% on the one-year ETF and 1.9% on the two-year ETF. This compares to the average money market fund yield of about 1.24%. An advisor who charges 30 basis points for managing fixed income could use the FITRs, make money on a cash position, and still provide a yield advantage on a client’s cash position.


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