Five Bond ETFs Worth A Closer Look

by on April 8, 2010 | ETFs Mentioned:

Fixed income ETFs have been one of the hottest growth areas in a rapidly-expanding industry. According to the ETF screener, there are now more than 100 bond ETFs available to U.S. investors, a significant increase from just one year ago. At the end of February, bond ETF assets totaled about $107 billion, an increase of more than 75% from the same period a year earlier. Much like the ETF industry as a whole, the bond space is very top-heavy; the vast majority of these assets–55% according to the latest figures from the National Stock Exchange–were held in five funds: TIP, LQD, AGG, SHY, and BND.

These ETFs are popular for a reason; they offer cheap, diversified exposure to some attractive corners of the fixed income sector. But there’s a lot more to the bond ETF universe than these super tickers. Below, we profile five fixed income ETFs unfamiliar to many investors that could be worth a closer look:

1. Market Vectors High Yield Municipal Bond Index ETF (HYD)

This ETF tracks the Barclays Capital Municipal Custom High Yield Composite Index, a benchmark that maintains a 25% weighting in BBB bonds and a 75% weighting in non-investment grade bonds. With interest rates near record lows (and expected to remain there for the foreseeable future), investors searching for current returns have begun to look beyond Treasuries to find an acceptable yield, and many have turned to high yield munis.

High yield municipal bonds are often issued by not-for-profit organizations such as charter schools and hospitals. As the name suggests, they are often found near the low end of the credit spectrum, but that doesn’t necessarily translate into a high default rate; according to a study done by Moody’s Investors Services of fixed-income default rates between 1970 and 2005 (PDF), the average cumulative rolling ten-year default rate for high-yield munis was 4.3% over that period. For high-yield corporate debt, it was nearly 33%.

For investors in the top tax brackets, HYD could be an interesting play; the tax equivalent 30-day SEC yield for those in the 35% bracket is a whopping 9.4% (although it should be noted that HYD is subject to the AMT). One potential speed bump: an average modified duration of 9.1 means that rate hikes could have an adverse effect on the share price of this fund. Still, with an expense ratio of just 0.35%, HYD offers an attractive yield at an attractive price.

2. Vanguard Short Term Corporate Bond (VCSH)

For years, LQD was, by default, the corporate bond ETF of choice. But Vanguard has jumped into the space with a suite of targeted corporate bond ETFs, including short, intermediate, and long term funds. VCSH tracks the Barclays Capital U.S. 1-5 Year Corporate Index, an index that consists of corporate bonds with a maturity between one and five years. For investors hunting yield but hesitant to venture into the realm of junk bonds, VCSH presents an interesting opportunity; the average credit quality of this fund is A2/A3.

Moreover, for those worried about the impact of eventual rate hikes, VCSH has an average duration of just 2.8 years, meaning that it will be in better shape than longer-dated funds when the Fed begins its next tightening campaign. By comparison, the Vanguard Long Term Corporate Bond (VCLT) has an average duration of 12.2 years; AGG’s effective duration is 4.53 years.

3. Planned End Date Muni Bond Funds

Municipal bond ETFs have been around for several years, and have attracted a fair amount of assets. There are currently 20 ETFs in the National Munis ETFdb Category and several more New York and California-specific funds. iShares recently launched a line of municipal bond ETFs unlike anything else on the market: a series of planned end date funds. So this item actually consists of six separate ETFs, each with a maturity ranging from 2012 to 2017 (MUAA, MUAB, MUAC, MUAD, MUAE, MUAF).

Each of these ETFs tracks an index that measures the performance of AMT-free, investment grade municipal bond debt. For investors looking to fill holes in their fixed income portfolio, exposure to a basket of muni debt issues maturing in a certain year may be an efficient way to go. Similar to HYD, these ETFs will be more beneficial to investors in higher tax brackets.

4. SPDR Barclays Capital Convertible Bonds ETF (CWB)

CWB is a relatively new fund that has grown tremendously since its launch almost a year ago. This ETF tracks the Barclays Capital U.S. Convertible Bond >$500MM Index, a benchmark that represents U.S. convertible bonds with issue sizes greater than $500 million. Convertible bonds can be exchanged, at the option of the holder, for a specific number of shares of the issuer’s preferred or common stock. As such, CWB maintains attributes of both stock and bond securities.

This ETF has gained about 30% since it began trading, a good real life demonstration of the potential for the effective call option present within a convertible bond. For investors looking to establish s decent current income return while maintaining upside potential if equity markets keep rising, CWB is an interesting option; this fund has a current yield of about 3.6%.

5. Grail McDonnell Core Taxable Bond ETF (GMTB)

There’s a mountain of evidence suggesting that active managers aren’t able to consistently add value, but most of this research concentrates on highly transparent, incredibly liquid equity markets. Bonds are a totally different story, since liquidity issues pop up pretty frequently (outside of Treasuries, of course). So some investors feel more comfortable with using active management for the bond portion of their portfolios, and we’d have a hard time coming up with a good reason not to.

GMTB is benchmarked against the Barclays Capital U.S. Aggregate Bond Index (the same benchmark tracked passively by AGG and BND), and as such it maintains exposure to all sectors of the U.S. investment grade bond market. GMTB is a relatively new ETF (launched in January 2010), so it’s a bit too early to compare results to the benchmark. But for investors more comfortable with active management of their fixed income portfolio, GMTB is one of the only ETF options.

In the equity space, active management typically implies a big jump in expenses (see the Five Most Expensive ETFs), but that’s not the case for GMTB. The 0.35% expense ratio is a significant jump from BND, but not unreasonable for a fixed income fund; the average expense ratio in the Total Bond Market ETFdb Category is 0.22%.

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Disclosure: No positions at time of writing.