by Aaron Levitt | January 8, 2014 9:50 am
The tapering and potential ending of the Fed’s quantitative easing programs is sending shockwaves throughout the fixed-income world. That’s because rising interest rates have a negative correlation with bond prices. But it doesn’t mean you shouldn’t consider a bond ETF.
The basic issue at hand is that as the Fed raises rates, a portfolio of fixed-income securities will likely lose value. And the longer the maturity of the bond, the bigger that loss will be. Essentially, for every percentage-point gain in yield, a 10-year bond will lose roughly 10% in price … and a 30-year bond will drop around 30%.
Those are some pretty hefty losses … especially considering nearly $33 billion of investors’ money is located in the broad Vanguard Total Bond Market ETF (BND) and iShares Core Total Aggregate U.S. Bond ETF (AGG). But with the need for income still there, bond investors are facing a quandary.
That is, unless they expand their horizons. The general ETF boom has now made some pretty “weird” and esoteric bond types available to the masses. And a few of these bond ETFs — while often ignored — could be the best way to get your income fix and navigate the Fed’s taper tantrum.
Here’s four of the best “weird” bond ETF investments to consider.
Bond ETF Yield: 2.74%
If the average investor is woefully under-allocated to international stocks, then he or she is tragically under-allocated to international bonds. That’s a real shame, as international bonds can actually be a great way to fight rising interest rates.
The key is that interest rates in various nations are completely different from each other. What’s going on in Singapore is very different than what Canada is doing. The fact that international rates are not perfectly correlated with each other and don’t rise at similar paces can actually provide a smoother ride for investors here in the U.S.
The PowerShares International Corporate Bond ETF (PICB) tracks investment grade corporate bonds from several developed market nations. Its portfolio includes bonds from heavy hitters such as the Royal Bank of Canada (RY) and BHP Billiton (BHP).
The key is that PICB has zero exposure to the U.S. dollar and the rising interest rates that affect our bonds. As a corporate bond ETF, investors get a slightly better yield (currently 2.74%) than a basket of international sovereign/treasury bonds.
Expenses for this bond ETF run at a cheap 0.50%.
Bond ETF Yield: 3.67%
While preferred stock has been widely adopted by the general investing public, convertible bonds have been largely ignored by portfolios. That’s a real shame, as the asset class can offer plenty of benefits amid rising interest rates.
See, convertibles are basically a bond with a stock option hidden inside. That option provides the issuer the ability to exchange the bond for shares of its own stock under certain conditions — generally when the price of the stock hits a certain point.
Historically, when interest rates surge — and borrowing costs rise — many issuers will convert their bonds … just as the stock markets swoon. That provides a nice total return for investors in their convertibles.
The only real way to play convertibles via ETFs is through the SPDR Barclays Capital Convertible ETF (CWB). Despite having over $2 billion in assets, CWB is still pretty ignored by the general investing public. That’s a shame because the basket of 101 different convertibles in this bond ETF has put up an impressive 14.78% annual return since 2009.
Meanwhile, CWB currently yields a market beating 3.67% distribution yield. And this bond ETF can be yours for a low expense ratio of 0.40%, or $40 per $10,000 invested.
Bond ETF Yield: 5.63%
The ETF boom has helped regular retail investors use some pretty advanced tactics in the portfolios. One of them is the hedge fund trick of long/short. Basically, a long/short strategy involves selling — or shorting — one type of security, while going long another.
The First Trust High Yield Long/Short ETF (HYLS) takes a long position in junk bonds for current yield while actively shorting U.S. treasuries. The basic idea for this bond ETF is that the short treasury position allows HYLS to remove some of the interest rate risk from its underlying portfolio.
The result is that investors still get the high yield from junk bonds without having to fear capital deprecation from rising interest rates. The short position ends up reducing the overall duration of the HYLS portfolio. And as an actively managed ETF, HYLS has ability to move in and out of different bonds without being tied down to a set index. That should help produce a higher overall long-term return.
The bond ETF isn’t cheap — currently with an expense ratio of 1.19% — but with a yield of 5.63% and the rising rate protection built in, it could be a great satellite position in any fixed-income portfolio.
Bond ETF Yield: 5.84%
Just like people, companies have “credit scores.” And just like you or I, various issues can affect those debt ratings.
Firms that have run into trouble and seen their debt rating fall from investment grade to junk status often face higher borrowing costs and bigger coupon payments on their bonds. For investors, it can be an opportunity to pick up some extra yield without adding that much more risk.
These bonds are called “Fallen Angel” debt and the Market Vectors Fallen Angel HY Bond ETF (ANGL) is the only fund that tracks these former investment grade bonds.
The bulk of the holdings in this bond ETF are rated BB, or just one notch below investment grade. That means the 93 different now-junk bonds in ANGL are actually pretty strong bonds. Issuers range from British investment bank Barclays PLC (BCS) and telecom CenturyLink (CTL). These aren’t necessarily the highest-risk companies and many have vast global sales networks.
In exchange for moving slightly down the credit ladder, ANGL investors are treated to a 5.84% distribution yield, while the duration is right in the sweet spot to battle rising rates. This bond ETF should definitely be on your radar.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.
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