Bond ETF Ideas: Room For Growth In Fixed Income Arena

by on March 14, 2011 | ETFs Mentioned:

The last few years have seen tremendous growth in ETF assets, as investors have gradually embraced the exchange-traded structure as a tool for establishing exposure to everything from emerging markets to micro cap stocks to commodities. Interest in bond ETFs has been particularly strong; according to year-end data from the National Stock Exchange, bond ETFs saw inflows of more than $26 billion in 2010 and finished the year with close to $130 billion. Those figures represent impressive growth, but considering the importance of fixed income to almost every investor portfolio and the well-known advantages of the ETF structure it is perhaps surprising that the bond ETF space isn’t bigger–a lot bigger.

Part of the explanation for the relatively slow adoption of bond ETFs may lie in the disconnect between the cash flow profiles of most products and those of individual bonds. A significant part of the “bond experience” is the repayment of principal upon maturity of a debt obligation–an event that investors in most fixed income funds don’t experience. When the underlying holdings of a fixed income ETF mature or are sold, the proceeds are generally not distributed to investors but rather reinvested in other securities that have entered into the “eligibility window.” The result is that many fixed income ETFs maintain a constant duration and risk profile, while many investors may want to adjust these factors over time. There is also evidence suggesting that tracking error is a major issue in most fixed income ETFs, and some believe that the rules-based indexing strategies create opportunities for front-running that can erode bond ETF performance [see Q&A With Matt Patterson: Are Bond ETFs Broken?].

But another explanation for the relatively small size of the fixed income ETF market may simply be the lack of a comprehensive product lineup. As we profiled last week, recent years have witnessed impressive innovation in the space; new products have included suites of target maturity date funds focusing on high yield bonds, investment grade corporates, and munis. There are a handful of ETFs focusing exclusively on Build America Bonds and a multiple options for accessing debt of emerging market issuers denominated in local currencies.

We’ve also seen the introduction of the first bond ETF linked to a fundamental index, the Fundamental High Yield Corporate Bond Portfolio (PHB), and the first senior loan ETF (BKLN). But there are still holes in the bond ETF map, creating opportunities for issuers to roll out new products. Below, we profile a handful of bond ETF innovations we think would be hits with investors [sign up for our free ETF newsletter]:

High Quality Junk Bond ETF

This may sound like an oxymoron, but a product that bridges the risk/return gap between investment grade funds like LQD and high yield products like JNK could be desirable for a number of investors. Ability to fine-tune credit risk is somewhat limited with the current lineup of fixed income ETFs, and further refinement on this risk metric could make for some powerful new products. Existing junk bond ETFs focus on a wide swath of credit ratings, and there is a significant gap in terms of both risk and return between an investment grade product like LQD and a high yield fund such as JNK:

30 Day SEC Yield 4.3% 6.2%
% Portfolio BBB+/- 30% 1%
Wtd. Avg. Coupon 8.4% 5.8%

Options to bridge this gap might include a “BBB Bond ETF” or even more segmented products focusing on specific credit ratings or durations. Such products could be appealing to both long-term buy-and-holders and those with more of a short-term focus.

Alternatives To Cap-Weighted Bond ETFs

The ETF boom has brought more widespread availability of alternative weighting methodologies in the equity space, with funds linked to indexes that utilize revenue weighting, earnings weighting, dividend weighting, equal weighting, and other fundamental weighting strategies surging in popularity. But in the fixed income space there has been much less progress in the “weighting revolution,” as cap-weighted products continue to dominate the ETF lineup.

In the equity space, cap-weighted products have a tendency to overweight overvalued equities and underweight undervalued stocks. In the fixed income world, cap weighting leads to larger weights in securities of the biggest debtors–a strategy that may be less than optimal for various reasons. Yet besides PHB and a proposed fund from State Street, the ETF world has been slow to come up with fixed income alternatives. If investors are ever to embrace ETFs as the most efficient means of achieving bond exposure, some refinements to the weighting methodologies available through the ETF structure are needed [see PHB: Different Kind Of Junk Bond ETF].

True Total Bond Market ETF

The 12 ETFs in the Total Bond Market ETFdb Category account for a huge portion of total fixed income ETF assets, and these products are popular options for those seeking one stop bond exposure. But the name of this category is perhaps a bit misleading, as funds like AGG and BND may not be as balanced as investors might believe.

AGG, for example, allocates about 33% of its holdings to Treasuries, with another 32% going to MBS passthough securities and 8% or so to agencies. In other words, the clear tilt is toward low risk, low yield debt issued by the U.S. government or one of its agencies. Moreover, debt within ten years of maturity makes up about 55% of holdings while debt with 25 years or more makes up about 30%; the intermediate duration curve is relatively light.

The weightings in AGG and BND are a function of the debt issuance patterns of the last several years; as the government’s debt burden has increased, so too has the allocation to these securities in aggregate bond indexes. In a low interest rate environment, that results in aggregate bond funds that deliver a less-than-impressive yield; AGG has an average yield to maturity of about 2.7%. A fund that maintains bigger allocations to corporate debt, including junk bonds, could be a more attractive option for simple, one stop bond exposure through an ETF.

Global Bond ETF

An equity portfolio limited to domestic stocks could hardly be considered well-diversified, yet many investors fail to venture beyond U.S. borders when it comes to establishing fixed income exposure. Investors seeking to diversify their bond exposure from a geographic perspective have the ability to do so through ETFs, with various funds focusing on developed market government debt, emerging market issuers, and even international corporate bonds. But investors seeking to access the global debt market through a single ticker have to turn to the mutual fund space; there are no ETF counterparts to funds like the Templeton Global Bond Fund (TPINX) or PIMCO Global Bond Fund (PIGLX) [see the Mutual Fund To ETF Converter].

Targeted International ETFs

Innovation in recent years has made it possible for investors to achieve exposure to equities in dozens of different countries, including small and previously hard-to-reach markets such as Vietnam [see Highlighting The Free ETF Country Exposure Tool]. Yet options for international exposure in the fixed income ETF arena are extremely limited; all of the funds in the Emerging Markets Bonds ETFdb Category or International Government Bonds ETFdb Category cast a wide net, investing in securities from issuers in multiple economies. Country-specific exposure simply isn’t available–unless the country you’re interested in happens to be the U.S.

Given the size of the global bond market and the importance of this asset class to both buy-and-hold investors and more active traders, it seems bizarre that there are no ETF options for investing in Japanese debt or Brazilian bonds. More granularity in the international bond space should be a sure winner, but no issuers have made this segment of their product lineup a priority.

There are certainly signs that innovation in this corner of the market is well underway. WisdomTree has filed for a number of more targeted fixed income funds, and Guggenheim recently detailed a China bond fund as well [for details on all new ETF launches, sign up for our free ETF newsletter].

Disclosure: Long JNK.