Rough Bond Landscape Sends More Investors Into ETFs

With corporate bond demand facing an uncertain period after a robust 2009, investors confront a hunt for yield in which bond funds could play an even greater role.

The use of exchange-traded funds to play the corporate bond market has soared in the past two years. High-yield corporate bond funds now make up 10 percent of the total ETF market, up from 1 percent two years ago, while high-grade bond funds now comprise 15 percent of ETFs, up from 6 percent in 2008, according to BofA Merrill Lynch Global Research.

The moves represent an increasing desire among investors to get a piece of the improving corporate structure in the U.S. while protecting against the volatile environment in global credit markets.

"The stock market isn't going to have a huge up year, so we're looking for yield everywhere we can get it," said Brian Peardon, wealth advisor at Harrison Financial Group in Citrus Heights, Calif. "We think ETFs are a good way for the average investor to participate in corporates, being able to have diversification and flexibility."

Following a year in which corporate bond prices—particularly high-yield—kept pace with the 64 percent rise in stocks from the March 2009 lows, the outlook in that regard is sketchy. Rising sovereign debt issues in Greece and elsewhere in Europe have darkened the outlook for bonds, and if the trend continues, companies may be forced to pay higher yield to attract investors to their debt offerings.

In the past week, high-yield bond funds saw outflows of nearly $1 billion, the largest such move in about five years. At the same time, credit default swaps, or the amount it costs to insure corporate debt, hit its highest level in three months.

Treasurys have been under pressure as well. The government said Tuesday that foreign demand fell the most on record in December as China slipped to No. 2 among US debt-holding nations behind Japan.

That kind of data makes investors nervous that the Treasury may have to start paying out higher yields even as the Federal Reserve remains cautious about its rate policy.

A recent survey from professional services firm Towers Watson showed just 46 percent of professional investors with a bullish view on high-yield bonds. Government bonds drew the largest percentage of bearish sentiment at 77 percent, a dichotomy that shows fixed-income investors with a preference for corporates—though not without reservations.

"It is not surprising that there is a high level of uncertainty in bond markets, given that we have limited experience with what happens when governments ease off the liquidity pedal," Carl Hess, head of global investment at Towers Watson, said in a statement.

That uncertainty helps fuel growth in ETFs, which cut down on volatility and provide solid yields even as prices fluctuate. ETFs are more liquid than mutual funds because they can be traded like stocks.

For instance, the iShares iBoxx Investment Grade Corporate Bond ETF yields 5.4 percent with an implied volatility of just under 7. By comparison, the SPDR S&P Depositary Receipts fund, the ETF proxy for the S&P, yields just over 2 percent, and the broad index has a volatility index above 22.

"What I sense from watching ETF flows and talking to institutional investors, there is still much skepticism about equity valuations and about their ability to sustain themselves," said Nicholas Colas, chief market strategist at ConvergEx Group, a New York-based institutional investor services firm. "That will continue to push money flows into alternative nonequity assets."

Though high-yield ETFs provide about twice the volatility of high-grade and have seen large outflows in 2010, their yield could prove attractive as the expected slow-growth market lurches forward.

The iShares iBoxx High Yield ETF, though down about 4 percent for the year, offers a 9.6 percent yield.

European Debt Concerns Linger

The high-yields actually provide some relative safety despite their risk. The cost to insure Western European government debt has passed that for U.S. corporate bonds for the first time, Barron's reported recently.

"Investors are going to start demanding a little more yield to take that risk going into 2010," said Kevin Mahn, portfolio manager for SmartGrowth Funds in Parsippany, N.J. "This is a year filled with great uncertainty. both political and economic, and with uncertainty comes great gyrations in the market on a day-to-day basis."

Mahn recommends investors use managed funds for high-yield bonds. Some ETFs are beginning to combine aspects of managed and passive funds.

Indeed, the global turmoil is likely to have myriad effects on the investment environment. Investors will need to be mindful of what happens in the developed economies of Europe as well as policy changes for growth in emerging markets.

"As long as we can maintain a pretty positive outlook on the recovery and corporate profits, that should keep a pretty solid demand for corporate bonds," said Kim Rupert, managing director of global fixed income analysis for Action Economics in San Francisco.

"There are also the little niggly worries now, with China starting to take back some of the stimulus and other countries moving in that direction as well. That might hurt the recovery down the road. That's still a big 'if.'"