Bond ETFs can help. With generally lower volatility compared to stocks, bonds have long held appeal to retirees seeking income, and bond ETFs are in many cases the least expensive options available. In fact, last year fixed-income ETFs enjoyed a record $92 billion in net inflows, according to CFRA. Here are four ways to incorporate bonds into a portfolio seeking additional income and less equity risk.
1. Go broad
For investors with a longer-term investment horizon, the first place to look within fixed-income is the most popular total bond market ETFs, including the Vanguard Total Bond Market ETF (BND) and the iShares Core U.S. Aggregate Bond ETF (AGG). These ETFs offer low fees, massive asset bases — important for liquidity and trading efficiency — and well-diversified exposure to the entire universe of investment grade bonds in the United States.
Take BND: It has $32 billion in assets and almost 18,000 holdings. It is one of the broadest ETFs an investor can hold and charges a minuscule 6 basis points annually, said Neena Mishra, director of ETF research at Zacks Investment Research. The iShares' option AGG has a similar investment profile and charges an even lower 5 basis points. It has about one-third of BND's holdings — 6,200 bonds.
2. Don't forget about inflation
One negative with BND and AGG is that both ETFs have outsized exposure to U.S. government and agency debt, keeping yields low, and making them susceptible to a rise in interest rates. "We know that inflation has finally starting rising after remaining muted for the past many years," Mishra said.
The Fed now seems ready to raise rates in March, barring unexpected, negative economic data.
To prepare for rising inflation, investors should consider adding Treasury inflation-protected securities (TIPS) ETFs to their core bond holdings, such as iShares 0-5 Year TIPS Bond ETF (STIP) or Vanguard Short-Term Inflation Protected Securities ETF (VTIP).
3. Include corporate bonds
Retirees in need of income should consider corporate bonds because, while riskier than government bonds, they are less risky than stocks. That is a happy medium for retirees.
Todd Rosenbluth, senior director of ETF and mutual fund research at CFRA, said the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD) is a good choice for a steady income stream. The fund offers diversified exposure to high-quality corporate bonds for a reasonable 15-basis-point annual fee. With more than $30 billion in assets under management, LQD is highly liquid and has returned 5.4 percent annually over the last decade. "These are companies that generate strong cash," Rosenbluth said.
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LQD only invests in bonds that mature in three years or more, which increases interest rate risk.
Mishra said investors with a shorter investment horizon should look at the Vanguard Intermediate-Term Corporate Bond ETF (VCIT). It also has a low fee of 7 basis points, and the focus on intermediate term bonds results in lower interest-rate sensitivity.
Rosenbluth pointed to the Vanguard Short-Term Bond ETF (BSV), which tracks investment-grade corporate and international bonds as well as U.S. government bonds with maturities of one to five years. It charges 9 basis points annually. "Fees are extremely important in general, but when rates may go up, it matters even more."