I am not a fan of bond exchange-traded funds (ETFs) for a couple of reasons.
First, while there is a theoretical difference in risk between bonds and preferred stock, the practical risk is not so large as to make the meaningful difference in yield worth owning most bonds.
Second, while most bond ETFs are broadly diversified, bond prices are subject to significant risks that include inverse correlation with interest rate movements. This is why my stock advisory newsletter, The Liberty Portfolio, will not likely own bond ETFs.
Remember, we are now in a rising rate environment. As rates go up, bond prices go down. They are also subject to overall economic risks. However, you can buy single-issue investment grade bonds that yield far more than most bonds, and for which these other risks do not exist. A corporate bond is issued with a specific yield. Its price will be much less subject to market interest rate movements because corporate bonds yield so much more.
Only if something happens to that individual issue will prices move and yields move with them.
Still, many investors like bond ETFs. If you’re a fan of these ETFs, I would avoid these three if you are investing for retirement.
Bond ETFs to Avoid: SPDR Barclays Capital High Yield Bnd ETF (JNK)
Expense Ratio: 0.40%, or $40 annually for every $10,000 invested
SPDR Barclays Capital High Yield Bnd ETF (NYSEARCA:JNK) is one of the go-to bond ETFs for those seeking higher yields, but it is also a terrible time to be holding JNK.
Take a look at the spread between high yield junk bonds and the five-year Treasury (make sure you are looking at the 10-year chart). This shows the premium one earns for owning junk bonds as opposed to Treasuries.
As you can see, during the financial crisis, when corporations were in big trouble and many risked default on their bonds, you earned a massive premium for owning those bonds. Why? Investors sold the bonds out of fear of default and bought safer Treasuries. Corporate bond prices moved down so yields went up, as Treasuries were purchased and prices moved up and yields moved down, widening the spread.
Now look at where the graph is today. It’s about as low as it has been in ten years, which means everybody has been buying, driving rates lower. Yet corporate bonds carry more risk than Treasuries, so the path of least resistance will be more sellers to eventually emerge, as we saw in 2014-2016 when oil prices crashed.
Bond ETFs to Avoid: Vanguard Extended Treasury Duration ETF (EDV)
Expense Ratio: 0.07%
Vanguard Extended Treasury Duration ETF (NYSEARCA:EDV) tracks the U.S. Treasury STRIPS 20-30 Year Equal Par Bond Index. A Treasury STRIP is a single coupon or principal payment on a U.S. Treasury, and it has been stripped so that it has individually traded components. These are zero-coupon bonds, by the way.
Obviously, these are long-term bonds with average maturity of 25 years. While EDV has done very well in the low-rate environment of the past ten years, I think the party is over for these bond ETFs.
EDV has cratered by 10% over the last few days, and while it may recover in the near-term, I think the party is over for the long-bond as rates continue to rise.
A yield around 3% also doesn’t make much sense when you can get preferred stocks yielding over 5% and as high as 9%. While not technically as safe as Treasuries, preferred stocks are extremely safe compared to most bond ETFs if you pick the proper issues.
Bond ETFs to Avoid: Vanguard Short-Term Inflation-Protected Securities ETF (VTIP)
Expense Ratio: 0.07%
Vanguard Short-Term Inflation-Protected Securities ETF (NASDAQ:VTIP) is not the “safe” ETF that everyone thinks. TIPS are a good idea in general, as far as allegedly protecting against inflation. Except, they don’t really protect against inflation because inflation is closer to 10% and not 3%.
So, as it is, I consider TIPS to be something sold to the public that are not what they claim to be. The other problem is that higher inflation usually also leads to higher interest rates, which means bond prices on these bond ETFs will fall. So that defeats the purpose.
But the bigger problem with these bond ETFs are that they are not diversified. VTIP in particular only holds 15 bonds, because new ones are issued each time another matures. So you are really only holding one type of Treasury bond that simply has laddered maturities.
When you consider that the largest truly diversified bond funds have literally thousands of bonds, you realize pretty quickly the problem here.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He does not own any stock mentioned. He has 22 years’ experience in the stock market, and has written more than 1,600 articles on investing. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.