How to Build a Bond ETF Portfolio

Among the most popular bond ETFs are two products in the Total Bond Market ETF Database Category: (AGG A) and (BND A). Both AGG and BND are linked to the Barclays Capital U.S. Aggregate Bond Index a broad-based benchmark that covers the investment grade U.S. bond market. For many investors, an allocation to one of these products–or to one of a number of similar offerings–accounts for the vast majority of the fixed income portfolio.

There’s certainly a lot to like about these products; they offer cheap exposure to asset classes that should be a core component of most long-term portfolios. But any strategy that involves using these ETFs as one stop shops for bond access is limiting in nature–and potentially costly in terms of risk/return optimization. While funds such as AGG and BND may cover a significant portion of the U.S. bond market, they only scratch the surface of the various types of fixed income securities available to U.S. investors.

Many ETFs that offer exposure to the investment grade U.S. debt market are dominated by Treasuries, a bias that results from the sheer size of the U.S. government’s debt obligations. The result is a meaningful concentration within a single issuer (or network of related issuers) that may be less than optimal for those seeking to construct a balanced long-term portfolio.

Be sure to see our Better-Than-AGG Total Bond Market ETF Database Portfolio.

Fortunately, there are a number of ETFs out there that can be used to round out fixed income exposure, offering cheap and efficient access to corners of the global bond market not covered by the most popular bond ETFs. Below, we profile several different types of bond ETFs that offer exposure not found in funds such as AGG and BND:

Municipal bonds generally feature interest payments that are exempt from federal taxes, making them appealing to investors in higher tax brackets. But these bonds can be useful tools to all types of portfolios, potentially enhancing the yields offered by debt issued by the U.S. government.

The National Munis ETF Database Category includes both broad-based and targeted options. In addition to funds such as the popular National AMT-Free Muni Bond ETF (MUB A), there are ETFs that focus on various durations and credit qualities, from low risk pre-refunded munis to more speculative high yield municipal debt:

• PowerShares Insured National Municipal Bond Portfolio (PZA B+): As the name suggests, this ETF gives investors exposure to AAA-rated, insured, debt publicly issued by U.S. states and their subdivisions. The underlying holdings of this fund are backed by an insurance policy that guarantees bond holders against losses resulting from a default by the issuer for the full term of the issue. Keep in mind that this boost in creditworthiness comes at the expense of a smaller yield.
• Market Vectors High Yield Municipal Index ETF (HYD A-): This fund may be appealing to yield-hungry investors who have a stomach for risk, as HYD invests a quarter of its assets in BBB-rated bonds and the remainder in non-investment grade debt. HYD can be a source of attractive yields for those willing to take on increased default risks.

Build America Bonds represent a unique segment of the municipal bond market and offer the potential to deliver attractive real returns with minimal risk of default to investors. The Build America Program was introduced under the American Recovery and Reinvestment Act of 2009 with the objective of reducing borrowing costs for municipalities looking to pursue necessary capital projects, such as work on public buildings, courthouses, schools, roads, and utilities.

BABs are simply taxable bonds issued by state and local governments, with the interest from the bonds being subsidized by the U.S. Treasury. The unique structure of BABs makes them appealing since they offer an attractive coupon from an investor perspective, while the interest burden is also reduced from the issuer perspective:

• PowerShares Build America Bond Portfolio (BAB A-): This ETF tracks the performance of U.S. dollar-denominated Build America Bonds publicly issued by U.S. states and territories, and their political subdivisions. BAB holds a broad portfolio of over 300 components with an average of 24 years to maturity.
• SPDR Nuveen Barclays Capital Build America Bond ETF (BABS C+): This fund provides similar exposure as BAB, however it features a shallower portfolio with a greater concentration in the top ten holdings. Its underlying debt holdings have an average maturity of 27 years.

Junk bond ETFs can be a source of attractive yield, especially in the current environment with record low interest rates. Because AGG and BND focus only on investment grade debt, they don’t include this segment of the U.S. bond market–which accounts for a huge portion of outstanding debt issues.

It’s also worth noting that junk bonds generally don’t provide the same diversification benefits that make investment grade fixed income components a vital portfolio holding; instead this asset class has a fairly strong correlation with broad equity markets, unlike AGG for example which bears a slightly negative relationship with the stock market:

• SPDR Barclays Capital High Yield Bond ETF (JNK A-): This fund is one of the most actively traded products in the junk bond ETF space. JNK’s broad portfolio of holdings, including healthy allocation to foreign corporate bonds, makes it appealing to anyone looking to establish long-term exposure in this lucrative asset class. HYG is a close competitor which offers an even broader portfolio of holdings, although the expense ratio is a bit higher.
• AdvisorShares Peritus High Yield ETF (HYLD B-): This unique offering from AdvisorShares seeks to offer investors a compelling way to gain exposure within the junk bond space by employing an active management strategy. HYLD avoids many of the highly leveraged buyouts which tend to dominate junk bond indexes, in addition to the flexibility to shift exposure to U.S. Treasuries in certain environments.

Most portfolios nowadays include significant allocations to international stocks, an asset class that investors have acknowledged is capable of bringing both diversification benefits and return enhancement advantages. Yet the fixed income portion of most portfolios consists entirely of U.S. debt, leaving out a portion of the global bond market that can add dollar diversification and allow investors to establish exposure to debt of sovereign issuers that may be on much more stable fiscal footing.

See also International Bond ETFs: Cruising Through All The Options.

Many of the new fixed income ETFs to debut in recent years have focused on bond markets outside of the U.S., and there are a number of both broad-based and precise ETFs for accessing this asset class.

International Corporate Bonds
Most of the ETFs in the Corporate Bonds ETF Database Category are dominated by debt of U.S. companies, but a couple products have an international focus, allowing for investors to expand the geographic scope of their corporate bond holdings.

• SPDR Barclays Capital International Corporate Bond ETF (IBND C): This ETF can help investors access the global investment-grade corporate bond markets outside of the United States. IBND’s holdings are primarily rated A or higher, and its holdings are equally split between foreign and U.S. holdings.
• PowerShares International Corporate Bond (PICB C): This fund gives investors similar exposure as IBND, however, PICB charges a smaller expense fee at the cost of having a portfolio half the size.

Emerging Market Bonds
The Emerging Markets Bonds ETF Database Category includes several different products that offer investors exposure to dollar-denominated bonds as well as those that are issued in the local currency. Those who are interested in gaining additional dollar diversification will likely be better off with issues denominated in foreign currencies versus the greenback.

• Market Vectors Emerging Markets Local Currency Bond ETF (EMLC A+): This ETF gives investors exposure to a basket of bonds issued in local currencies by emerging market governments.
• PowerShares Emerging Markets Sovereign Debt Portfolio (PCY B+): This fund employs a proprietary indexing methodology, allowing for investors to tap into the fixed-income corner of emerging market economies. Investors should note that PCY has under 100 holdings in total, all of which are denominated in U.S. dollars

Ex-U.S. Developed Market Treasuries
For investors seeking to add some international flavor to their Treasuries allocation, there are a number of appealing options in the International Government Bonds ETF Database Category

• S&P/Citigroup International Treasury Fund (IGOV A): This fund offers exposure to treasury bonds issued in local currencies by developed countries.
• SPDR Barclays Capital Short-Term International Treasury Bond ETF (BWZ B+): This ETF gives investors access to the performance of fixed-rate local currency sovereign debt of investment grade countries outside the United States.

Investors should also consider international TIPS funds from the Inflation-Protected Bonds ETF Database Category since they can potentially help to reduce overall portfolio volatility and establish a formidable defense against inflation.

• SPDR DB International Government Inflation-Protected Bond ETF (WIP B+): This ETF gives investors exposure to the performance of inflation-linked government bonds from developed and emerging market countries.
• iShares Global Inflation-Linked Bond Fund (GTIP C+): This fund is a great all-in-one TIPS fund since it gives investors global exposure to inflation-linked sovereign debt, but it also includes U.S. Treasuries.

In addition to the broad-based funds, investors can gain country-specific access to three international markets through a suite of ETNs from PowerShares:

• PowerShares DB German Bund Futures ETN (BUNL C+): This fund is intended to gives investors exposure which is identical to a long position in Euro-Bund futures issued by the German government.
• PowerShares DB Japanese Government Bond Futures ETN (JGBL A): The underlying assets of this ETF are Japan-government issued debt securities (JGBs) with a remaining term to maturity of not less than 7 years and not more than 11 years.
• PowerShares DB Italian Treasury Bond Futures ETN (ITLY B-): This ETF tracks the performance of Republic of Italy-government issued debt securities (BPTs).

Access to floating rate bonds may take on appeal as interest rates are bound to rise at some point in the foreseeable, which would in turn negatively impact other bond ETFs that are sensitive to interest rate changes:

• iShares Floating Rate Note Fund (FLOT B+): This fund measures the performance of U.S. dollar-denominated, investment grade floating rate notes. The underlying holdings of FLOT have a remaining maturity of greater than or equal to one month and less than five years.
• Investment Grade Floating Rate Bond ETF (FLTR B-): Investors can gain access to U.S. dollar-denominated floating rate notes issued by corporate issuers and rated investment grade by at least one of three rating services. FLTR is linked to an index that consists almost entirely of financial firms.

For more help on narrowing down Bond ETF options, be sure to use our ETFdb Screener.

Disclosure: No positions at time of writing.