Never mind the depressed yield income being squeezed from bond investments around the world. The current yield cycle will inevitably change and furthermore, it doesn’t alter the fact that bonds are still a major asset class that all diversified and architecturally sound portfolios should have exposure to.
A bond is a debt instrument issued by a government or company that borrows the funds for a specified period of time at a variable or fixed interest rate. Investors who buy bonds are paid interest on the money they loan to the bond issuer or borrower. The bulk of returns that come from investing in bonds is from income.
Because bond returns are generally less than stocks over the long run, minimizing investment cost is a crucial element of successful investing in the fixed income market. In this article, we’ll examine a few bond ETFs that offer affordable, diversified and core exposure to this major asset class.
“Core fixed income is a strategy designed to reduce risk and/or generate income,” said J.R. Rieger, global head of fixed income, S&P Dow Jones Indices. “Indices come into play to track the performance of the core market, i.e., investment grade sovereign bonds, sovereign inflation-linked bonds, and corporate bonds in both U.S. and global currencies.”
Similar to stocks, bonds can be subdivided into two basic groups: domestic and foreign. Bonds can be further classified by the type of issuing entity: corporate, government or municipality. Finally, a bond’s credit rating is another classification factor that is determined by an independent agency that rates the ability of the borrower to fulfill its financial obligations. Top rated bonds are referred to as “investment grade debt” whereas lower rated bonds are called “high yield” or “junk bonds.”
Now let’s analyze five bond ETFs that offer exposure to key segments of the global bond market. Each of these particular bond ETFs are good proxies of the fixed income markets they track and can rightly be designated as core building blocks for a bond portfolio.
U.S. Bond Market
The Schwab US Aggregate Bond ETF (SCHZ) covers the total US bond market and owns investment grade debt like mortgage backed assets and bonds issued by top rated U.S. corporations and the U.S. government. The fund is classified as an intermediate-term bond fund, meaning the average bond duration or maturity is greater than 3½ years and less than six. SCHZ contains market exposure to more than 2,000 different bond issues.
High Yield Bonds
Bonds with a lower credit rating generally command higher yields and that’s exactly how the SPDR Barclays High Yield Bond ETF (JNK) is invested. JNK owns publicly issued U.S. dollar denominated high yield corporate bonds with above-average liquidity. The fund includes non-investment grade, fixed-rate, taxable corporate bonds that have a remaining maturity of at least one year.
If you want core exposure to the U.S. junk bond market, JNK is a good place to start.
Muni Bond Market
For tax-conscious investors in a high tax bracket, municipal bonds are a haven because they offer tax-exempt income.
The iShares National AMT-Free Muni Bond ETF (MUB) covers the U.S. municipal bond market by owning more than 2,000 municipal bonds in more than 45 different states. The munibonds held inside MUB are rated investment grade and have maturities of less than seven years.
For exposure to international bonds, check out the Vanguard Total Intl Bond ETF (BNDX). The fund owns international government, government agency, corporate, and securitized debt all issued in currencies other than the U.S. dollar. BNDX includes exposure to more than 3,000 international bond issues and owns top rated investment grade debt.
Inflation Protected Bonds
Certain bonds, like TIPS, are designed as a hedge against inflation. The iShares Global Inflation-Linked Bond ETF (GTIP) owns TIPS, also known as treasury inflation protected securities. TIPS are government bonds whose face value rises with inflation and GTIP owns inflation linked bonds from both domestic and international governments around the world. GTIP is a great choice for owning the entire global TIPS marketplace in a single trade.
For portfolios with heavy fixed income exposure to single bond issues, finding a smooth transition away from individual bonds to more diversified funds can be a challenge.
Unfortunately some investors are reluctant to switch into diversified bond funds even though the broader diversification may greatly reduce financial risk. Here’s the common hangup: Most divsersified bond funds and ETFs have no maturity date, because maturing bonds are constantly replaced with new bonds with longer-dated maturities. As a result, fixed income investors accustomed to receiving their principal at the end of certain period will generally balk at owning bond funds.
The Guggenheim BulletShares ETFs offer a robust choice for advisors with bond investing clients in dilemma. The company offers exposure to a diversified portfolio of both investment grade and high yield bonds with targeted yearly maturity dates. The corporate bonds within the BulletShares ETFs have yearly maturities from 2015 to 2024, while the high yield bonds range from 2015 to 2022. After the fund reaches its respective maturity date, a distribution of cash is made to the bond shareholder and the fund is liquidated.
In the future, advisors and their clients are likely to have many more excellent bond ETF choices to build out their core exposure.
In 2014 alone, S&P Dow Jones Indices launched nearly 700 new indices, including the S&P Aggregate Bond Index Family. This new bond index lineup will measure the performance of publicly issued investment grade debt in various regions around the world. Some of these indexes are already being licensed for future ETF products.
In the meantime, there are plenty of broadly diversified choices for advisors to build core exposure to bonds at an affordable cost.