by Daniel Putnam | September 6, 2012 8:55 am
Mentioning the phrase “bond ETFs” in public is usually a sure-fire way to send people running in the opposite direction. After all, bonds are like an annual checkup — we all need them to one extent or the other, but nobody really wants to think about them.
Maybe that’s why less than 15% of the ETFs available in the United States provide access to the bond market, even though bonds make up about 75% of the world’s capital markets.
Clearly, bonds aren’t getting a fair shake.
Fortunately, the growth of the ETF industry has provided investors with ways to invest in areas of the fixed-income market that in the past were extremely difficult to access. Are some of these products boring? Perhaps. But they just might be the answer for some yield-oriented investors.
With that in mind, here are some smaller bond ETFs that might have escaped your notice:
That’s right: There’s a fund that invests in short-term high-yield bonds. If this is a market segment you haven’t thought much about, there’s a good reason: The PIMCO 0-5 Year High Yield Corporate Bond Index Fund (NYSE:HYS) is the only ETF that offers a pure play on the short end of the high-yield market.
While most high-yield funds have to sell securities with maturities of one year or less, this PIMCO fund has no such requirement — it can hold its bonds until they mature. As a result, the fund has an average maturity of 2.7 years, versus 6.8 for SPDR Barclays Capital High Yield Bond ETF (NYSE:JNK).
The 30-day SEC yield is lower than JNK’s — at 4.7% versus 6.1% — but that comes with the benefit of lower volatility. This fund might just be the answer for investors who want to beef up their portfolio yield without taking on the risks associated with longer-term high-yield bonds.
Along the same line, the PowerShares Senior Loan Portfolio (NYSE:BKLN) offers another lower-risk alternative to high yield.
Senior loans are loans to below-investment-grade companies that banks can package and securitize. The loans are so named because they are senior in the capital structure to plain-vanilla bonds. This equates to lower default risk, but with a yield that’s competitive (currently 4.8% for BKLN). And as is the case with all asset classes that offer above-average yields, the popularity of bank loans has risen significantly in recent years.
While bank loans will be hit hard in risk-off markets — just like high–yield bonds — they offer two benefits to investors. First, they have an exceptionally low correlation with investment-grade bonds, making them a true source of diversification. Second, senior loans are offered with floating rates, meaning that there’s an element of protection against price declines when prevailing rates rise. With U.S. Treasury yields so low, this might come in handy in the years ahead.
If you’re looking for a way to capitalize on bond market volatility without entering the world of leveraged ETFs, the PIMCO 25+ Year Zero Coupon U.S. Treasury Index Fund (NYSE:ZROZ) is for you. Since zero-coupon bonds don’t pay interest, they have an extremely high duration (or sensitivity to moves in prevailing rates). As a result, this ETF produces stock-like returns. Below is a sampling of the fund’s returns in select short-term time periods:
May-August 2010: +35.2%
September 2010-January 2011: -26%
July-September 2011: +59%
January-March 2012: -10%
April-May 2012: +23%
From these numbers, it should be evident that ZROZ isn’t a fund for the faint of heart. But for traders who want to express an opinion on the bond market, this fund provides serious bang for your buck.
These products provide a middle ground that combine the benefits of bonds and bond funds: They offer the security-level diversification typical of an ETF, but they also have a set maturity date at which investors can receive a return of principal. This helps offset the problem inherent in perpetual bond funds: the unknown amount of principal coming back to the investor when the fund is sold. Note, however, that this principal is not guaranteed as is the case with many target-date funds — if an underlying issue defaults, investors will suffer some loss of principal.
Target-maturity corporate and high-yield funds are offered by Guggenheim under the BulletShares family, and a series of five municipal bond products is issued by iShares. The Guggenheim and iShares websites offer more information on the strategies employed by these funds.
This is a prime example of an asset category where investors didn’t have a low-cost option for a pure play until ETFs came along. Now, there are no fewer than eight funds that invest in this space:
Are these ETFs volatile relative to the average bond fund? You bet. Any disruptions in the global markets will undoubtedly take a disproportionate toll on this group of funds, particularly those lower on the list. It’s also a small and unproven market segment — together, these eight funds have less than $300 million in assets. Comparatively, the Vanguard Total Bond Market ETF (NYSE:BND) has $113.3 billion.
Still, this relatively new category offers investors a way to pick up some extra yield and add some diversification to their portfolios.
Investors also have a way to play yield curve movements without having to establish their own long and short positions: iPath US Treasury Flattener ETN (NYSE:FLAT) and iPath US Treasury Steepener ETN (NYSE:STPP), together with the three-times leveraged versions of these portfolios.
The volume isn’t there yet, but these funds bear watching for investors who are interested in making more exotic plays on the bond market. If nothing else, they provide a quick visual reference regarding the movement of the U.S. Treasury curve.
None of these funds will make you rich, to be sure. However, they just might provide solutions for investors who are looking to diversify into bonds and still get a decent yield with some room for capital appreciation.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.
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