The Right (and Wrong) Way to Tweak your Bond Exposure

This article examines the key factors to take into account before tweaking your fixed income exposure with ETFs.

• Do consider the credit risk. This is the most obvious risk for fixed income investors, and that is the risk of default when it comes to the debt issuer. Securities like U.S. Treasuries and other government bonds carry little to no credit risk whereas high-yield “junk bonds” come with a higher degree of credit risk.

• Do consider the interest rate risk. This is another major risk, this one dealing with how interest rate changes will impact bond prices. Longer term bond ETFs will carry a higher duration risk than short-term dated ones, meaning they are more prone to declines as rates rise.

• Do consider the credit spread as it will impact how cheap (wide spread) or expensive (narrow spread) a particular segment of the bond market is at any given time. Learn more about credit spreads here.

• Do consider the bid-ask spread. Fixed income ETFs carry a higher trading cost than their equity counterparts due to the larger bid-ask spreads in the market. According to XTF, the average bond ETF has a bid-ask spread of 0.39%, compared to just 0.31% for equity ETFs.

• Don’t just go after the highest-yielding bonds. You can enhance your fixed income exposure in other ways, such as focusing on reducing your portfolio’s duration, that is its sensitivity to interest rate changes, or increasing the overall credit quality.

• Don’t ignore where we are in the business or monetary cycle as it will help to guide your allocation decisions.

• Don’t tweak your fixed income exposure just for the sake of tinkering with your portfolio. Sometimes it pays to be hands off; rebalance only when your investment strategy says to do so.

• Don’t ignore your currency exposure. Remember that foreign bond ETFs may be denominated in either US dollars or local currency and so it pays to consider which approach, that is hedged or unhedged respectively, more closely aligns with your strategy.

• Don’t feel pressured to go for granular bond ETFs just because they are available. Remember that ETFs were designed with simplicity in mind and so it’s perfectly OK to stick with broad-based funds.

• Don’t forget to do a thorough comparison of seemingly-identical ETFs because more often than not, there are meaningful differences between very similar products. Start with the ETFdb Head-to-Head tool then move onto fact sheets.

• Don’t have a home country bias, meaning that you shouldn’t alienate bonds outside of the United States from your portfolio. As seen in the equity space, there are also budding opportunities in developed, as well as emerging, debt markets that are now accessible via ETFs. See also ETFdb’s Guide to International Bonds ETFs.

Here are three types of bond ETFs to consider in today’s environment.

1. Beef up yield with municipal bond funds. This often forgotten corner of the bond market packs three punches: great credit quality, decent yield, and interest earned is exempt from federal taxes. Munis are a popular option for investors in higher tax brackets looking to round out their current income stream in ways beyond chasing after high-yield.
2. Fortify your portfolio by decreasing duration and improving credit quality with short-term government bonds or money market funds. If you’re worried about what an interest rate hike, and especially an unexpected one, then it may not hurt to supplement your bond exposure with some safe haven, short-term treasuries. Also, albeit not very attractive from a yield standpoint, investors could also park cash in money market ETFs.
3. Expand beyond US dollar exposure with foreign currency-denominated bond ETFs. Some options that hold debt securities denominated in local currency include Van Eck’s (EMLC A+) and WisdomTree’s (ELD B-).

In addition to Total Bond Market ETFs, consider accessing some of the most popular slices of the fixed income universe, including:

• Bank Loans
• Floating Rate
• International Corporate
• International Treasury
• Investment Grade Corporate
• Money Market
• Junk Bonds
• Municipal Bonds
• TIPS
• Treasuries

See All Bond ETFs.

Consider the above list of reminders as a research starting point before your next bond ETF reshuffle. Don’t forget to look under the hood before making an allocation to any one product; as they say, the devil is in the details.

Follow me @SBojinov