Bond funds look like the skunks at Wall Street’s garden party this summer. Ben Bernanke’s comments about possibly scaling back the Fed’s mammoth $85 billion-a-month spending spree has spooked stakeholders in all flavors of bond exchange-traded funds. The interest-rate uncertainty drove bond ETFs and mutual funds into the dirt — as is clear from the record $61.7 billion in outflows so far in June, according to TrimTabs Investment Research.
It makes sense when you think about it: When interest rates rise, bond prices usually fall as investors bail on lower-yield debt. Still, despite this mass exodus from bond funds — or perhaps because of it — be mindful of this adage from Warren Buffett: “Uncertainty is the friend of the buyer of long-term values.”
Consider the iShares S&P National AMT-Free Municipal Bond Fund (MUB), which on June 24 was trading nearly 4% below the fund’s net asset value, according to the New York Times’ Dealbook.
Industry gurus like DoubleLine Capital’s Jeffrey Gundlach believe the current bond selloff is a “liquidation cycle” that will end within weeks — once the 10-year Treasury hits 2.75%.
With fear and uncertainty causing many retail investors to bail out of bonds, it soon could be the right time for a value play in various debt-based ETFs. Let’s break down the pros and cons of four different bond ETFs:
iShares S&P National AMT-Free Municipal Bond Fund
Pros: Munis, which are issued by local governments to raise money, tend to be less risky than corporate bonds; U.S. municipal debt also tends to be safer than emerging-market issues. Municipal bonds’ tax-free status can be a benefit as well. MUB has a three-year average return of 5.6%.
Cons: Munis might be safer, but they are not default-proof, as the recent news out of Detroit proves. MUB’s performance this month is its worst since September 2008.
Verdict: MUB’s pain might be investors’ gain; the selloff has dumped shares of the fund into the bargain basement. And savvy investors appear to have found the muni market’s bottom — MUB was up over 2% by midday Wednesday.
SPDR Barclays High-Yield Bond ETF
The aptly tickered SPDR Barclays High-Yield Bond ETF (JNK) invests in corporate bonds that are rated below investment grade. The ETF has a whopping $12 billion in assets under management, offers a current yield of 6.7% and charges 0.4% in expenses.
Pros: For investors seeking yield, JNK is worth considering. A junk-bond ETF allows investors to diversify among a large number of bond issues, potentially mitigating the risk of buying individual bonds. JNK has delivered a three-year return of about 10%, and despite the ETF’s recent volatility, the longer-term outlook for this asset class remains bright.
Cons: High-yield ETFs like JNK have been hammered harder than their sector peers — the ETF is down nearly 6% this month alone. Options traders also are betting against JNK — during the past month, options volume in JNK was four times average, with bearish puts outpacing calls by 11-to-1.
Verdict: The selloff in JNK likely has not found its bottom yet, so a better deal might be available in a week or two. Still, JNK is in oversold territory now, presenting a potential opportunity for investors looking for yield, but unwilling to chase it.
PowerShares Emerging Markets Sovereign Debt Portfolio
The PowerShares Emerging Markets Sovereign Debt Portfolio (PCY) invests in U.S. dollar-denominated debt of emerging market governments including Pakistan, Korea and Eastern European countries such as Poland, Romania, Lithuania and Hungary. PCY has $2.48 billion in assets, an expense ratio of 0.5% and a current yield of 4.8%.
Pros: Emerging-market bond ETFs were one of the asset-class stars last year, delivering a one-year return of nearly 11.5%. The growth potential of emerging markets has driven gains, and credit ratings actually have been improving in many emerging-market countries in recent years.
Cons: PCY’s emerging-market bonds tend to be riskier than U.S. debt. Also, nearly 87% of PCY’s holdings are rated BBB or below; more than half of that total is non-investment grade (BB or below). Emerging market bonds have been particularly pummeled by word that the Fed could scale back quantitative easing. As a result of the adverse market, several emerging-market bond auctions — most recently in Romania — have been scrapped.
Verdict: PCY is the classic risk-reward scenario — it’s not best suited for risk-averse investors with a short investment horizon, and volatility is par for this course. That said, it can play a valuable role as a small part of a well-diversified portfolio.
ProShares UltraPro Short 20+ Year Treasury ETF
If you’re bearish on Treasuries, actively monitor your investments, and have the stomach for risk and volatility, investing in the ProShares UltraPro Short 20+ Year Treasury ETF (TTT) is another way to go.
TTT is a triple-leveraged, inverse debt ETF that aims to deliver three times the opposite performance of the Barclays U.S. 20+ Year Treasury Bond Index. TTT is comparatively small with net assets of about $42 million; it also has a higher-than-average expense ratio of 0.95%.
Pros: TTT has gained 46% since May 2 — a meteoric rise that was helped immensely by Bernanke’s comments about tapering off its bond buying. The relatively new ETF, launched in June 2012, is a sophisticated fund that uses swaps and derivatives to meet its daily objectives. Although TTT is thinly traded compared to its double-leveraged sibling, ProShares UltraShort 20+ Year Treasury (TBT), the 3x ETF will maximize returns if the bears devour the long bond.
Cons: Like all inverse, leveraged funds, TTT is not intended to be a buy-and-hold investment — if you take that approach, you’re likely to lose your shirt and pants. TTT is rebalanced every day and works best as a hedging tool to take advantage of a short-term, bearish move on Treasuries. Check out FINRA’s disclosure on these ETFs here.
Verdict: If the Fed reduces Treasury bond purchases and interest rates rise, investors stand to see additional gains from TTT and other Treasury bear ETFs. But make sure you go in with your eyes wide open — and be prepared to actively manage your holdings.
As of this writing, Susan J. Aluise did not hold a position in any of the aforementioned securities.