ETF Center

Since their introduction, exchange-traded funds (ETFs) have become a popular investment vehicle and the number of ETFs available has grown rapidly. One way to think of ETFs is as baskets of stocks, like mutual funds, but you can buy and sell them on the exchanges intra-day like stocks. Learn more about ETFs through the ETF Center, powered by Morningstar®. Once confident in your knowledge, as a Siebert client you can review our ETF Research, which includes an ETF Screener and Profiles from Interactive Data Corporation. Quickly review ETF performance data, holdings and other detailed information to help you make an informed investment decision.

Morningstar.com Logo Getting a fix on fixed-income ETFsBy Morningstar

The menu of bond ETFs has expanded exponentially in the last several years as more investors are becoming comfortable with the ETF structure and concerns about stocks have sent many people into the perceived safety of fixed income.

But are ETFs the best way to get your bond allocation? How should you evaluate a bond ETF and see if it makes sense for you?

The Basics As with any ETF purchase, the first rule is to know what you own. Generally, bond ETFs track one of the major fixed-income indexes in the same way that many equity ETFs track an index such as the S&P 500. Bond indexes serve as proxies for segments of the fixed-income market, be it Treasury securities, corporate bonds, or municipal bonds. They often have massive numbers of securities, but ETFs hold only a representative sample. It would be unwieldy to hold all of the bonds, and oftentimes many of the issuances trade very infrequently, making them poor candidates for inclusion in an ETF.

It's also crucial to understand how investing in a bond ETF is different than buying individual bonds. Simply put, bonds have maturity dates, whereas indexed bond investments do not. That is to say, if you were to buy a 10-year IBM bond with a 3% yield, you'd know that for the next decade you're guaranteed to get a 3% yield and then you'll have your principal returned (absent a default, of course). On the other hand, a bond index that tracks 10-year corporate bonds will have a constantly moving yield as maturing bonds are replaced by new issuances.

To conceptualize a bond or bond ETF's sensitivity to a movement in interest rates, investors should refer to a metric called "modified average duration." For example, if interest rates were to instantaneously rise by 1%, a bond ETF with a duration of 10 years would be expected to see a corresponding 10% price haircut. The drop in price of the bond compensates for the fact that newer bond issuances will be available at higher yields following an interest-rate hike.

The shifting yield of a bond ETF means that investors face constant interest-rate risk while the risk becomes smaller for individual bond investors as the security reaches maturity. This means that fixed-income ETFs aren't great options for a liability-driven investment, such as saving for a child's college education. A laddered portfolio of individual bonds with specifically tailored maturities designed to offset a given individual's future liabilities could be a better bet. (It's worth keeping an eye on innovations in the bond ETF world. An increasing number of ETF providers now offer products with set maturity dates that return your capital after a set number of years instead of reinvesting to keep a fixed average maturity. New products like those could help make more bond ETFs more useful to long-term investors.)

Take a Broad, Diversified Approach To a large degree, ETF providers have approached the bond market in much the same way that they have other market segments--by slicing and dicing. Several of the more recent domestic bond funds divide the market into various maturity ranges. Choices vary from an ETF that focuses on one- to three-month Treasury bills to one that invests in 10- and 30-year Treasury bonds.

Some investors will surely attempt to use these narrow ETFs to make bets on the direction of interest rates. But we'd urge you to avoid that temptation. It can be very difficult to accurately time interest-rate swings. That's why our favorite bond managers rarely make big interest-rate calls. The risks can be noteworthy, but the payoff is typically slim.

Stretching for yield by investing in long-term bonds has a similarly unattractive risk-reward profile. Yes, you'll earn a bit more on a long-term fund, but you'll put up with more ups and downs, and volatility is not what most investors want from their core bond fund. The average long-term bond fund returned 6.2% per year on average over the past 15 years, while the average intermediate-term bond fund returned 5.4%. But the long-term bond fund experienced more than twice as much volatility, as measured by standard deviation of returns. What's more, long-term bonds experience sharper pullbacks when interest rates increase.

That's why most investors are better off keeping most of their fixed-income allocation in a low-cost, broadly diversified intermediate-term bond fund. Most offer respectable returns and at the same time serve as ballast for your portfolio. One option is to find a low-cost ETF that tracks the Barclays Aggregate Bond Index. The Barclays Agg serves as the ubiquitous reference point in the bond market, in much the same way as the S&P 500 Index does in the equity arena.

Investors seeking broad exposure should note that the Barclays Aggregate Bond Index excludes a wide range of securities, including floating-rate, Treasury Inflation-Protected Securities, tax-exempt municipal, convertible, foreign, and high-yield bonds.

Another option for core bond exposure is the actively managed PIMCO Total Return ETF (BOND), which is the exchange-traded fund version of the very successful PIMCO Total Return mutual fund. By most measures, BOND is the highest profile actively managed ETF today. It follows a top-down investment process that leans on Bill Gross and the PIMCO investment committee for their secular outlook on the global economy and interest rates and should be a viable option for most investors seeking a core bond holding that focuses on high-quality intermediate-term bonds. ETFs and mutual funds have risks, charges and expenses, and you should carefully consider such risks, charges and expenses before investing. For a complete discussion of these risks, charges and expenses, and other important information, you should read the prospectus carefully. You can obtain a copy of the prospectus by calling Siebert's Mutual Fund Department at 800-872-0666 or contacting the ETF or mutual fund company directly.

Municipal Bond ETFs Municipal-bond funds in general are most suitable for investors in high annual tax brackets for use in their taxable accounts. The reason is that interest income from municipal bonds is tax-free at the federal level. Therefore, investors with the highest marginal tax rates are able to best utilize the tax-shielding profits and maximize their return on the bonds.

Historically, municipal bonds have been one of the quieter corners of the investment world. There was the occasional single-municipality meltdown, such as what happened to Orange County, Calif., in 1994, but what made these events so newsworthy was the actual rarity of these kinds of disasters. That has all changed, however, as municipalities have been blind-sided by falling tax receipts in the wake of the housing crash. But defaults are still rare because of the stigma associated with defaulting.

Muni ETFs bring three advantages to the table--low costs, diversification, and liquidity. Low costs are powerful in muni land because expenses eat up a large portion of the modest total returns generated by the typical muni fund. If an increase in defaults is likely, the diversification inherent in an ETF like iShares S&P National Municipal Bond (MUB) will help cushion the blow. And given the fact that individual municipal bonds are fairly illiquid after they've been issued (reflecting most investors' preference to buy and hold them until maturity), holding a percentage of a municipal-bond allocation in more-liquid ETF form will give investors the ability to sell if they get in a jam--without the risk of getting gouged by the trading spread.

It's important to note that ETFs aren't the only cheap way for individual investors to gain muni exposure and diversification. Vanguard Intermediate-Term Tax Exempt Mutual Fund (VWITX) has an expense ratio of 0.20% (matching the cheapest of the muni-focused ETFs), and you don't have to pay a brokerage commission to invest in it. ETFs and mutual funds have risks, charges and expenses, and you should carefully consider such risks, charges and expenses before investing. For a complete discussion of these risks, charges and expenses, and other important information, you should read the prospectus carefully. You can obtain a copy of the prospectus by calling Siebert's Mutual Fund Department at 800-872-0666 or contacting the ETF or mutual fund company directly.

Supplemental Bond ETFs As the bond landscape has grown, more wide-ranging options are now available to investors, including TIPS, high-yield funds, and emerging-markets bonds.

Of these supplemental offerings, we think TIPS ETFs hold a lot of promise. It can make sense to add some inflation protection to your bond allocation via a TIPS fund. The TIPS market is very efficient and not terribly complex, so a low-cost indexing approach works well.

When it comes to high-yield ETFs, we're more skeptical. When Morningstar examined high-yield bond returns, we found that the most attractive bonds are the least liquid, smallest issues in the high-yield index. But such issues are very hard to buy, and especially so for an ETF, which has to maintain liquidity and is traded throughout the day. Because high-yield ETFs have very little ability to own any of these very illiquid securities in the high-yield space, they have lower returns historically.

On the international front, given all the concerns about rising debt in the developed markets, investors have also been interested in the bonds of emerging markets, which have higher growth rates and low comparative debt levels. An emerging middle class has been driving strong domestic economic growth in these countries, which should bolster a healthy and sustainable rise in sovereign wealth. This in turn has allowed emerging countries to maintain sound fiscal policies, more-flexible currencies, a higher savings rate, and a growing private pension system.

However, interested investors need to be prepared to weather higher volatility in an emerging-markets bond fund versus a traditional U.S.-only bond fund due to currency fluctuations, in addition to the fact that emerging markets still have increased political and economic risks. ETFs such as the actively managed WisdomTree Emerging Markets Local Debt ETF (ELD) can give investors exposure here with an expense ratio that is significantly cheaper than many open-end mutual fund peers. ETFs and mutual funds have risks, charges and expenses, and you should carefully consider such risks, charges and expenses before investing. For a complete discussion of these risks, charges and expenses, and other important information, you should read the prospectus carefully. You can obtain a copy of the prospectus by calling Siebert's Mutual Fund Department at 800-872-0666 or contacting the ETF or mutual fund company directly.


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