Bond ETFs have ridden a wave of massive cash inflows and robust returns in 2012. Now, fixed-income investors face a conundrum: hold on to their positions and settle for low yields amid possible “bubble” conditions, take on even greater risk in stocks or flee to cash and earn negative returns after inflation.
Fortunately, the world of bond ETFs offer investors enough choices — 223 funds with an aggregate value of $243 billion, to be exact — to give them plenty of ways to
The Best Purchase May Be the One You Don’t Make
The challenge for bond ETFs in 2013 is straightforward: Yields are now so low that there’s almost no latitude for the market to deliver total returns much beyond its yield. This is a view recently set forth by PIMCO chief Bill Gross and DoubleLine founder Jeffrey Gundlach, both of whom are looking for mid-single-digit returns for the bond market in 2013.
At the same time, the potential downside is significant if inflation ticks up or growth comes in above expectations, driving up yields and causing prices to collapse. While this scenario is seen as being unlikely to occur — especially with the Fed maintaining its low-rate stance and continuing to support the market through aggressive quantitative easing — investors need to protect against the potential risks.
With this as the backdrop, the key to success in 2013 may not necessarily be which ETFs to choose, but which to avoid: namely, bonds with the highest sensitivity to interest rate movements. A prime example is iShares Trust Barclays 20+ Year Treasury Bond Fund (NYSE:TLT). While it offers a 30-day SEC yield of just 2.72%, it has a duration of 17.1 years. This means if long-term Treasury yields were to climb just a half-percent in the year ahead, the fund would lose about 8.6% on a price basis.
The takeaway: There’s little margin for error on the long end of the yield curve. And this isn’t just applicable to TLT — the same can be said for other, popular long-term funds such as Vanguard Long-Term Corporate Bond ETF (NYSE:VCLT) and Market Vectors AMT-Free Long Municipal Index ETF (NYSE:MLN). It also goes for big-name bond index funds with a heavy weighting in U.S. Treasuries, such as the Vanguard Total Bond Market ETF (NYSE:BND).
So, is the answer to move into safer, short-term bonds? If safety is the top priority, yes. But if you’re looking for returns, you certainly won’t find them in funds like Vanguard Short-Term Bond ETF (NYSE:BSV), which yields just 0.51%. At this point, investing in short-duration funds is a surefire recipe for negative real returns.
The Right ETFs for 2013
The way to navigate the conundrum set forth above is to look for funds that can offer two features:
- Decent yield and the potential for some extra total return if rates stay even or continue to fall.
- A low correlation with U.S. Treasuries.
This approach leads to some smaller ETFs, but investors may find that digging deeper into lesser-known areas of the bond ETF universe will pay off in 2013. Three market segments represent potential sources of opportunity.
Short-Term High-Yield Bonds
A prime example of ETFs that offer both yield, potential upside and low sensitivity to the Treasury market are PIMCO 0-5 Year U.S. High Yield Corporate Bond Index Fund (NYSE:HYS). The fund has a lower yield than the more popular iShares iBoxx $ High Yield Corporate Bond Fund (NYSE:HYG) – 3.85% vs. 5.4% – but in exchange investors can get a portfolio with lower volatility than the typical high yield fund, as well as lower rate sensitivity than broad-based index funds. Investors who are interested in this category can also consider SPDR Barclays Short Term High Yield Bond ETF (NYSE:SJNK).
While these funds will get hit if the broader high yield sector takes a dive, the damage will be less than it would be with HYG or SPDR Barclays High Yield Bond ETF (NYSE:JNK). There’s no rush to get into either HYS or SJNK, however: High-yield has been performing well in the past month, so investors may be able to get a better entry price by exercising some patience.
Guggenheim’s Target Maturity High Yield Bond Funds
Guggenheim offers a series of seven high-yield funds with the name BulletShares, which mature each year from 2012 through 2018 and carry tickers ranging from BSJC to BSJI. (The 2012 fund, BSJC, is set to close at year-end).
Each fund invests in bonds scheduled to mature in the specific year denoted by the name of the fund, and at the end of each year, the fund will close and return principal to shareholders. While there’s no guarantee an investor will receive all of principal back, the only way to lose a substantial amount of principal is if one of the issuers defaults — and since the funds are invested in higher-quality securities, that’s relatively unlikely.
An example: the Guggenheim BulletShares 2012 High Yield Corporate Bond ETF (NYSE:BSJC) opened at $25.26 in January 2011, and closed at $25.37 on Dec. 19 — a little more than two weeks prior to its maturity date. Naturally, the longer-dated the fund, the more volatile it will be in the near term. But with these funds, investors at least have the option of holding to maturity in order to offset their short-term losses, which isn’t the case with standard bond ETFs.
The key benefit of these funds in 2013: Investors can customize their yield and risk exposure, and they can gain the peace of mind that they can wait out losses if high-yield bonds turn south in the year ahead.
International and Emerging Market High Yield Funds
Fund such as Market Vectors International High Yield Bond Fund (NYSE:IHY) (30-day SEC yield: 5.58%) and Market Vectors Emerging Markets High-Yield ETF (NYSE:HYEM) (6.27%) are almost stock-like in terms of their expected volatility, so don’t think of these as “safe” bets for 2013. In addition, these foreign high-yield funds certainly have their own set of risks, including the global credit cycle and shifts in investor appetites.
However, they’re unique in the sense that they have almost no relationship with the U.S. interest rate cycle — as evidenced by their low correlations with TLT since they opened earlier this year. Further, they provide a way to pick up yield without diving into funds such as JNK and HYG, which are up 13.9% and 12.6%, respectively, in the past year.
The Bottom Line
All three segments suggested here are more volatile than the average bond ETF. However, they are among the few ways to manage interest rate exposure and still earn inflation-beating yields. At a time of extreme uncertainty for the bond market, investors may find that unconventional thinking will deliver the best results.