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Create Your Own Bond Portfolio Using ETFs

Product proliferation in the fixed-income space supports portfolio-construction flexibility.

Timothy Strauts, 12/10/2010

We often encounter investors who own as many as eight different funds to cover their equity exposure but only one or two bond funds for their fixed-income exposure. Conventional asset allocation theory dictates that investors should have at least 30% of their portfolio in bonds. We find it perplexing that investors don't show the same level of attention and differentiation to the fixed-income portion of their portfolio as they do their equity stakes. This disproportionate tilt toward completely passive investing in fixed income could be the result of less familiarity to the composition of the Barclays U.S. Aggregate Bond Index, which is the most widely followed U.S. bond index. The two largest ETFs that track this index are iShares Barclays Aggregate Bond AGG and Vanguard Total Bond Market BND. Many investors buy these funds for their entire bond allocation because both offerings offer a simple way to get access to the U.S. bond market in a low-cost package.

There is nothing wrong with simplicity; in fact, the benefits can be immeasurable. However, the current composition of the Barclays U.S. Aggregate Bond Index may surprise some investors. This index replicates the U.S. investment-grade-bond market based on market weight, so bond types with the most issuance have the highest weight in the index. The current index consists of 44% U.S. government securities (Treasury/agency), 30% mortgage securities, 19% corporate securities, and 7% foreign securities. The index has been a great choice for investors over the past 10 years, as it has returned 6.04% per year. The main reason for this performance is a period of declining interest rates. In the last decade, the 10-year Treasury yield has gone from 6.02% in July 2000 to 2.96% today. Investors need to consider that, at some point, yields can't go lower, and will start to rise. When this will happen is unknown, but you can start to prepare your portfolio today.

The table above is a diversified bond portfolio made up of bond ETFs focused on individual market segments. It offers more diversified exposure and reduces the overweight positions in U.S. Treasuries and mortgage bonds. Using ETFs to create your own bond portfolio can help reduce large overweight positions in the index, incorporate investments not represented in the index, and allow you to tailor the portfolio to your own unique risk tolerance and time horizon. That being said, our weighting strategy provides a fundamentally similar portfolio to the Barclays U.S. Aggregate Bond Index, but you can easily adjust the results on your own by changing the weightings. The overall portfolio presented above has a duration (a measure of interest-rate sensitivity) of 4.7 years, which is similar to the index's duration of 4.5 years. The portfolio's distribution rate is 4.06%, which is higher than the index's 3.33%. On average, the portfolio has lower credit quality but is still investment-grade.

Let's review the holdings and discuss the rationale for each selection.

iShares Barclays 3-7 Year Treasury Bond IEI
IEI was chosen among many Treasury ETFs because of its similar duration to the broad index. A 15% holding reduces the U.S. Treasury and agency exposure by 29%. With the great performance of government bonds over the past 10 years and historically low interest rates, it may make sense to reduce exposure to this area of the market. While not an immediate concern, IEI, with a yield of 1.8%, provides no protection from inflation in the future. Long-term inflation, since 1925, averages about 3% per year.

iShares Barclays TIPS Bond TIP
Treasury Inflation-Protected Securities, which are not part of the Barclays U.S. Aggregate Bond Index, offer a yield that adjusts depending on increases or decreases in inflation. The current five-year TIPS break-even rate (the yield spread between a five-year TIPS bond and a five-year Treasury note) is at 1.62%. This means the market is expecting an inflation rate over the next five years of 1.62%. An investment in this ETF will provide a hedge if the market is wrong and inflation is higher. By investing equal amounts in this ETF and IEI, we are attempting to neutralize our position on inflation or deflation.

iShares Barclays MBS Bond MBB
The mortgage-backed securities in MBB are rated AAA because they are backed by the U.S. government. Investors might be wary of investing in mortgage bonds considering the current real estate market problems, but the key feature of bonds issued by Fannie Mae and Ginnie Mae is that they guarantee payment of principal and interest. So, even if a large percentage of homeowners default on their mortgages, the bonds will still pay their interest payments on time. The high-quality nature of the portfolio means it will have similar returns to a U.S. Treasury bond over the long term. Over the last three years, MBB has had a 0.69 correlation with IEI. Mortgage bonds carry prepayment risk because homeowners have the ability to pay more than the minimum payment or pay it off completely in a refinance. However, an efficient market predicts the level of prepayment when pricing a mortgage bond. If interest rates rise unexpectedly, there will be lower prepayments than forecast, because fewer people will be able to refinance, and returns will suffer. Investing 20% in MBB compared with 30% in the index will allow the portfolio to diversify into other areas less correlated with U.S. Treasuries and with lower risks in the event that interest rates rise.

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