| Bond Market ETFs - Which Ones Should You Use? |
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The Sound Investor Series #8 Bond Market ETFs - Which Ones Should You Use? When you have finished putting together an investment plan suited to your needs, you need to determine what to buy to carry out your plan. I think Exchange-Traded Funds (ETFs) are very good products for investors looking to invest in either the stock or bond markets. ETFs are both low-cost and tax-efficient investment vehicles. Today I want to discuss the ETFs used for investing in the bond market. Let's start by briefly talking about bonds in general. As you may know, a bond's risk comes from two primary sources, its credit quality and its maturity. A bond's credit quality reflects the likelihood that the issuer can pay the holder the interest as it comes due and the principal when the bond matures. The US government's credit is considered to be the highest and therefore, its bonds are the safest. Corporations come in a variety of credit qualities and their bonds can be considered safe, somewhat risky or junk depending on the company. Right now the market considers the bonds of companies such as General Electric and Exxon to be very safe; Time Warner and Sprint's to be somewhat risky; and General Motors bonds to be very risky or junk. A bond's maturity, or how long it will be outstanding, is the other major risk. Generally speaking, when the maturity of a bond increases, it is more risky. This is because the longer a bond is outstanding, the more time there is for things to go wrong, such as inflation. And inflation is the main worry of long-term bond holders. One measure of a bond's risk, due to its maturity, is duration. The shorter a bond's duration, the safer it is. So if you think interest rates are going higher, it is best to stick with low duration bonds or funds. When inflation is low, as it is now, investors are agreeing to buy 10-year US government bonds that yield about 4.25%. But if inflation picks up to 5% or higher, as it was in the 1970s, these investors will fall behind. On the other side, if inflation falls further, these investors will be happy with the yield they receive. Combining these two risks, credit quality and duration, the safest investments are US government issued debt with short maturities. At the opposite end of the risk spectrum are long-term junk bonds offered by poorly rated companies such as General Motors. Now back to ETFs. At the current time, there are six ETFs that track the bond market. Three of these only invest in US Government issued notes and bonds. The iShares Lehman 1-3 Year Treasury Bond Fund (ticker: SHY) tracks the shorter-term securities in the US government bond market; the iShares Lehman 7-10 Year Treasury Bond Fund (IEF) tracks medium-term notes and bonds and the iShares Lehman 20+ Year Treasury Bond Fund (TLT) invests in long-term bonds. As you might expect all these funds have low yields. The SHY currently yields 3.63% and its duration is 1.7 years; the IEF is 3.95% and 6.6 years and the TLT has a yield of 4.31% with a duration of 13.3 years. In the corporate bond world, the iShares GS $ InvesTopTM Corporate Bond Fund (LQD) is designed to track higher credit quality or investment grade corporate bonds. These investments are more risky than US government bonds and the yield is higher. Right now this fund yields 4.72% with a duration of 6.7 years. The iShares Lehman Aggregate Bond Fund (AGG) is one way of combining the safety of US bonds with the higher yields of debt offered by government sponsored entities and corporate bonds. About 25% of the fund is invested in US government bonds and another 40% in government related entities such as Fannie Mae. AGG is currently yielding only 3.71%, but it has a low duration of 4.3 years which will help protect it from falling too much if interest rates go higher. The last fixed income ETF available is the iShares Lehman TIPS
Bond Fund (TIP). This fund invests in US Treasury Inflation Protection
Notes which are designed to protect investors from inflation. The
current yield is only 1.48% and its duration is 5 years, but if
inflation comes back this fund should do well. Ed Hynes, CFA, is President of Farm Creek based in Rowayton, CT. (203) 838-1025. This series of articles is available at farmcreeksecurities.com. Before putting money in any investment, you should carefully consider your investment objectives; and the risks, charges and expenses of any investment. Past performance is not an indication of future performance and there are risks to investing including the loss of principal. © Copyright 2005 | Back to the top | Back to the previous page | This site uses frames to navigate. If you do not see the navigation menu on the left part of your screen, please click here to refresh this site. © 2004 Farm Creek. All rights reserved. Unauthorized access is prohibited. |
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