Creativity on the product development front has become a defining characteristic of the ETF industry, as the surge in the number of ETF offerings in recent years has been driven not by duplication but by innovation. Many of the new fund launches are first-to-market concepts, offering exposure to asset classes or strategies not previously available within the ETF wrapper. The bond ETF space in particular has seen a number of major developments in recent years, and many of the ETF newcomers have become popular among investors and furthered huge asset growth rates.
PowerShares isn’t generally thought of as a major player in the fixed income ETF arena, but the Wheaton, Illinois-based firm behind the ultra-popular QQQQ has rolled out a couple first-to-market products over the last year. The first was more of an adjustment; the company switched the index underlying its junk bond ETF from a Wells Fargo benchmark to the RAFI High Yield Bond Index. That adjustment was more than a cosmetic change; the new index determines components and weights using fundamental factors such as cash flow and dividends.
Fundamental Bond ETFs
Most fixed income benchmarks give the biggest weightings to the biggest debt issues–meaning that firms with a higher debt burden tend to receive bigger weightings than those with minimal debt. That has obvious ramifications for the risk/return profile–and potentially undesirable consequences in a credit crunch or downturn. Because the index underlying PHB uses cash flow metrics to determine holdings, it will be different from funds like JNK and HYG. PHB can be thought of as a high quality junk bond ETF–seemingly an oxymoron but a fair description of a fund that bridges the gap between investment grade corporates and riskier junk debt funds [see PHB: Different Kind Of Junk Bond ETF].
There are dozens of equity ETFs linked to fundamental indexes, but PHB is the only one to take this approached to fixed income investing. That could change though, as State Street recently filed details on a fund that would use return on assets, interest coverage, and current ratio to determine holdings.
Senior Loan ETF
The other innovation from PowerShares in the fixed income space came in the recently-launched Senior Loan ETF (BKLN), a fund that offers exposure to floating rate debt issued to companies that are generally below investment grade. This fund has appeal for investors looking to avoid interest rate risk, as the underlying securities pay interest at a predetermined spread to a reference rate (usually LIBOR). Generally, increases to interest rates result in a decline in the value of bonds since the returns become less attractive relative to new issues. But because BKLN invests in floating debt, the effective duration is minimal. Because the underlying debt holdings are generally issued in connection with leveraged buyouts, there is substantial credit risk–which comes with attractive expected returns.
There are a number of mutual funds offering exposure to senior loans, also known as leveraged loans, but BKLN is the first of its kind in the ETF wrapper. This fund has been a hit with investors; the fund gathered assets of more than $50 million in its first week or trading [see Bond ETFs To Avoid Interest Rate Risk].
Target Date ETFs
Most bond ETFs are unlike their underlying holdings in that they are designed to operate in perpetuity and generally to offer a similar duration throughout time. Whereas individual bonds make a payment of principal upon maturity, most bond ETFs sell holdings before they mature and use the proceeds to buy new holdings eligible for inclusion in the underlying index. The result is a disconnect between the “yield experience” of individual bonds and bond ETF, as well as differences in the evolution of duration and interest rate risk (individual bonds become less risky as they approach expiration, but most bond ETFs have no set expiration).
For liability-based investors–meaning those who are using bonds to fund an expected outflow in the future–the structure of most bond ETFs can be problematic. But in recent years, a number of target date ETFs have debuted that are designed to more closely replicate the cash profile of a single bond while offering the diversification benefits of an ETF. iShares was the first to tap into this market, debuting a suite of target date muni bond ETFs early in 2010. Guggenheim has since rolled out similar funds targeting both high yield corporate bonds and investment grade corporate bonds, giving investors a number of options for fine tuning duration exposure or planning to fund future liabilities [see Are Bond ETFs Broken?].
Emerging Market Bond ETFs
An equity portfolio comprised exclusively of U.S. stocks would be considered woefully non-diversified by most investors. But when it comes to fixed income many fail to utilize geographic diversification, investing exclusively in debt of U.S. issuers. Just as funds in the Emerging Markets Equities ETFdb Category can be nice complements to developed market stocks, those in the Emerging Markets Bonds category can potentially add both return enhancement and diversification benefits to a portfolio.
The first emerging markets bond ETFs were the iShares USD Emerging Markets Bond Fund (EMB) and PowerShares Emerging Markets Sovereign Debt Fund (PCY), both of which debuted in late 2007. Both of these funds invest in debt that is issued by emerging market governments or companies but denominated in U.S. dollars; more recent innovation has given investors options to access emerging market debt that is denominated in the local currency. These securities offer diversification against the U.S. dollar, and as such can be expected to outperform their greenback-denominated counterparts when the dollar loses ground against emerging market currencies [see ETFs For The Forgotten Asset Classes].
There are now three ETF options for exposure to emerging markets debt denominated in local currencies:
- WisdomTree Emerging Markets Local Debt Fund (ELD)
- Market Vectors EM Local Currency Bond Fund (EMLC)
- SPDR Barclays Capital EM Local Bond ETF (EBND)
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Disclosure: Long JNK.