As the lineup of exchange-traded products has expanded dramatically in recent years, financial advisors have found themselves with more tools at their disposal than ever before. The extreme granularity of many of the equity products out there allows for cheap, low maintenance targeting of specific corners of the investable universe, while the development of some increasingly complex products has opened up strategies that were previously inaccessible.
But perhaps the most impressive innovation in recent years has come on the bond side of the market, where the arsenal has expanded considerably over the past two years. Whatever your objective for the fixed income side of client portfolios, odds are there is an ETF that can be used to help you out. Below, we highlight ten common objectives when it comes to managing a bond portfolio–as well as the ETFs that can be used to achieve those goals [for more ETF insights, sign up for the free ETFdb newsletter]:
1. Dollar Diversification
Historically, the bond portfolios of U.S. investors have been dominated by securities denominated in U.S. dollars. But recent innovation in the ETF space has delivered up dozens of options for achieving access to debt denominated in currencies beyond the greenback, ranging from the Canadian dollar to the Chinese yuan. For those looking to achieve some degree of dollar diversification in their portfolios, the ETF options are numerous:
2. Fine Tune Duration
When evaluating the risk components of fixed income securities, investors tend to focus on the credit risk components–the risk that the issuer will be unable (or unwilling) to make good on their obligations. Interest rate risk, however, can be considerably more important in certain environments, as moves in prevailing benchmark rates can have a major impact on bond valuations (rates and prices generally move in opposite directions) [see also Bond ETFs That Steer Clear Of Interest Rate Risk].
There are number of ETFs out there that can be used to fine tune the interest rate risk taken on in a portfolio. Those looking to extend duration have a number of long-dated ETFs such as the Vanguard Long-Term Bond ETF (BLV), Long-Term Corporate Bond ETF (VCLT) and Barclays 20 Year Treasury Bond Fund (TLT). Conversely, those looking to shorten up duration might like products such as Short-Term Corporate Bond ETF (VCSH) or Barclays 1-3 Year Credit Bond Fund (CSJ).
3. Beef Up Yield
With interest rates continuing to plumb record lows, many investors have become more active in their quest to achieve a meaningful current return from their fixed income portfolio [see Six Juicy High Yield Bond ETFs For 2012]. Of course, higher yields generally are achieved through taking on additional risk, but for those willing to increase the volatility a bit there are a number of options out there for juicing yields.
For investors looking to beef up the yield from their fixed income holdings, there are a number of ETF options:
4. Plan Cash Flows
Most bond ETFs deliver a “cash flow experience” that differs quite a bit from actual bonds; because ETFs generally operate indefinitely, there is no return of principal that occurs when investors hold an individual security. But for those looking to plan against a future liability or to gradually reduce duration over time, there are a number of “target date” ETFs out there that are designed to function more like traditional bonds and deliver a repayment of principal upon maturity [see 12 Rapid Fire ETF Ideas For 2012]. These ETFs have the potential to be useful for a wide variety of investors, ranging from a family planning for college tuition to a multi-billion dollar pension contemplating future obligations.
There are currently multiple suites of target date bond ETFs, covering three different types of bonds:
- Target date munis (MUAA, MUAB, MUAC, MUAD, MUAE, MUAF)
- Target date junk bonds (BSJC, BSJD, BSJE, BSJF)
- Target date investment grade corporate bonds (BSCC, BSCD, BSCE, BSCF, BSCG, BSCH)
5. Preserve Capital
For investors who are less concerned about maximizing current returns and more focused solely on preserving the value of their assets, there are ETFs that fall much closer to the “zero risk” end of the spectrum. A couple of active ETFs function essentially as money market funds, striving primarily to preserve capital by minimizing both credit risk and interest rate risk:
- PIMCO Enhanced Short Maturity Strategy Fund (MINT)
- Guggenheim Enhanced Short Duration Bond ETF (GSY)
6. Protect Against Inflation
In the wake of massive injections of liquidity into the global financial system in recent years, it should be no surprise that investors are concerned about an upcoming climb in inflation [see Inflation-Focused ETPs]. While the effectiveness of Treasury Inflation Protected Securities (TIPS) are debatable, those who believe these bonds will offset inflation have a number of choices from the ETF lineup. There are currently a dozen different TIPS ETFs, including funds that target short term securities (STIP, STPZ), long-dated TIPS (LTPZ), international TIPS (WIP, ITIP), and the global market (GTIP).
7. Round Out Emerging Markets Exposure
Many investors have increased their allocations to emerging markets in recent years, utilizing funds such as EEM or VWO to beef up exposure to the stock markets of developing countries. There are also ETFs for those looking to tap into the bond markets of these economies, asset classes that can deliver both attractive current returns and diversification against the dollar [see also Better-Than-AGG Total Bond Market ETFdb Portfolio].
8. Eliminate Interest Rate Risk
For those looking to steer clear of interest rate risk altogether, there are some interesting ETFs that have debuted in recent months that hold floating rate debt. While the vast majority of bond ETFs are dominated by fixed rate debt, funds such as the iShares Floating Rate Note Fund (FLOT), Market Vectors Investment Grade Floating Rate ETF (FLTR), and SPDR Barclays Capital Investment Grade Floating Rate ETF (FLRN) focus on debt securities whose coupon payments adjust based on movements in benchmark interest rates.
For those concerned about the adverse impact of a rate hike campaign on debt valuations, the floating rate bond ETFs mentioned above can be compelling ways to strip out interest rate risk while still capturing the component of returns associated with credit risk.
9. Maintain Some Upside
Most bond ETFs offer access to traditional fixed income securities that deliver relatively stable returns compared to equities but that miss out on the potential upside of a stock investment. There are, however, a couple ETFs that deliver access to securities that generally act like bonds but keep some of that upside potential on the table. Specifically, the SPDR Barclays Convertible Bond ETF (CWB) and PowerShares Convertible Securities Portfolio (CVRT) both hold convertible bonds, securities that deliver coupon payments similar to traditional bonds but also afford the holder the right to convert into equity (generally at a predetermined ratio).
For those willing to sacrifice a bit of return for some upside potential, convertible bond ETFs might be worth a closer look.
10. Max Out Tax Efficiency
When it comes to the effective returns realized on just about any security, the tax situation of the investor will go a long ways towards determining how much falls through to the bottom line. The universe of bond ETFs consists of a wide range of tax treatment; some securities are fully taxable, while others are entirely tax exempt [see also Tax Loss Harvesting With ETFs: 6 Ideas To Lower Client Liabilities].
Muni bonds have long been a popular choice with investors in higher tax brackets, since the tax-exempt nature of these securities can be an effective way to maximize the cash collected. The lineup of muni bond ETFs is extremely diverse, including products that target New York, California, high yield munis (HYD), short-term munis (SUB), long-term munis (MLN), Build America Bonds (BAB), and insured munis (PZA).
Disclosure: Long ELD.