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ETFs for investors who need bond income

A decade ago, investors were still trying to figure out how to use the first bond ETFs. Three iShares Treasury ETFs and one iShares investment-grade ETF launched in July 2002. Now there are more than 265 bond ETFs and assets exceed $275 billion.

Assets have continued to pour in this year. Fixed income ETFs are 15 percent of the U.S. exchange-traded product market, but in the first five months of this year saw 54 percent of the inflows, according to BlackRock. In May, more than $11 billion flowed into fixed income products, across all bond asset classes. U.S. government ($7.2 billion)--holding bonds with relatively strong credit profiles—was the leader, followed by high yield ($1.2 billion)--holding bonds with relatively weak credit profiles.

Bond ETFs can be used to manage interest rate exposure tied to the Federal Reserve, credit quality as investors seek greater yield from lower-quality bonds and to capture global fixed-income opportunities.

A trader signals an offer in a Treasury note options pit at the CME Group in Chicago.
Getty Images
A trader signals an offer in a Treasury note options pit at the CME Group in Chicago.

iShares Core Aggregate Bond (AGG), which has $17 billion in assets, is among the most popular bond ETFs. The ETF is well-diversified across U.S. Treasurys, U.S. mortgages and agency bonds, as well as investment grade corporate bonds. S&P Capital IQ believes many investors are using AGG for their core fixed income exposure and strategically increasing exposure to certain bond investment styles.

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AGG has a 2.0 percent 30-day SEC yield and the expense ratio is just 0.08 percent, well below the 0.85 percent for the average Lipper core bond mutual fund. With an average duration of 5.2 years, investors should expect AGG's price to decline by 5.2 percent if interest rates were to increase by 100 basis points.

Speaking Fed's language using bond ETFs

The Federal Reserve just voted to further taper its bond-buying program, reducing its monthly purchases of mortgage and Treasury bonds by an additional $10 billion to $35 billion. Consensus expectations are the Fed will begin increasing rates in 2015, though the exact timing remains unknown.

Indeed, the aggregated forecasts of Fed officials, published Wednesday, showed a small increase in the average expected level of the Fed's benchmark interest rate at the end of 2015, with the median for 2015 rising to 1.2 percent from 1.125 percent. Nonetheless, the 10-year Treasury bond essentially yielded between 2.45 percent and 2.80 percent since early February, after falling initially in January from just more than 3 percent; it closed Wednesday at 2.61 percent.

In the last 18 months, as Fed tapering became the major topic of conversation in the bond market, investors actively used ETFs to change the interest rate sensitivity of their portfolios. In 2013, short maturity funds (those with maturities of three years and below) added $36 billion of new assets, while funds with all other maturities saw outflows of $8.7 billion. One of the popular ETFs was Vanguard Short-Term (BSV) which has an average duration of just below three years, but a modest 0.8 percent 30-day SEC yield. BSV saw $4.8 billion of inflows in 2013, according to ETF.com, but just $450 million year-to-date through June 16.

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Indeed, in the first five months of 2014, short-maturity funds gathered $9.4 billion, but were outpaced by inflows of $31 billion to all other maturities. Vanguard Long-Term Bond (BLV) has a 4 percent yield, but has duration of 14 years, suggesting it takes on significantly greater interest rate risk. However, BLV has added $103 million in 2014, after $217 million of outflows last year. Both BSV and BLV have expense ratios of 0.10 percent.

Managing credit quality in bond ETFs

Investors can change the credit sensitivity of their portfolios through one of 48 investment-grade offerings if they believe that corporate credit quality will remain strong. Standard & Poor's investment-grade (bonds rated BBB or higher) composite spread relative to Treasurys was 142 basis points on June 17. The investment-grade composite spread is tighter than its one-year moving average of 168 bps and its five-year moving average of 193 bps.

During May, investors put over $5.3 billion into these products, which include iShares iBoxx Investment Grade Corporate Bond (LQD). LQD, with a 0.15 percent expense ratio, has a 3.2 percent 30-day SEC yield and holds bonds mostly rated A or BBB from rating agencies that operate independently from S&P Capital IQ.

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The Standard & Poor's speculative-grade (B rated and below) composite spread was recently at 393 bps, tighter than its one-year moving average of 453 bps and its five-year moving average of 595 bps. For those prepared to take on such credit risk, they can choose between one of 30 high-yield offerings.

One popular high-yield bond ETF is iShares iBoxx High Yield Bond (HYG) that has a 0.50 percent expense ratio and holds mostly bonds rated BB and B. In exchange for their elevated credit risk, investors receive a 4.2 percent yield. Alternatively there are a number of ETFs including those from PowerShares and First Trust that invest in senior loans that have elevated risk but with interest rates that reset after 90 days.

Going on global bond ETF hunt for yield

Of course, non-U.S. governments and corporations issue bonds too and, in many cases, offer compelling yields. One such offering is SPDR Barclays International Corporate Bond (IBND), which has a 0.55 percent expense ratio. The ETF's country exposure is largest in France, the United Kingdom and Germany, with just minimal exposure to emerging markets.

For investors that want more direct emerging market exposure, there are 20 such bond offerings. The largest is iShares JP Morgan US Emerging Market Bond (EMB), which despite its name and 4.3 percent 30-day SEC yield, has 64 percent in assets in investment-grade bonds. While issued in Brazil, Mexico, Turkey and Russia, the bonds are U.S. dollar-denominated, which reduces the risks as well as the potential benefits of currency swings. EMB has a 0.60 percent expense ratio.

For investors willing to take on that currency risk, there are a number of alternatives includes those offered by Market Vectors and WisdomTree.

As investors look to tactically build a global fixed income portfolio that reflects their views on the direction of interest rates, credit quality and geopolitics, there's a lot of choices.

—By Todd Rosenbluth, S&P Capital IQ Director of ETF Research

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