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Consider This Before Joining the Bond ETF Stampede

Individual bonds and bond ETFs are completely different animals.

John Gabriel, 02/12/2010

Upon reflecting on the 2008 credit crisis, many investors might've realized that they were too concentrated in equities and that a balanced portfolio of stocks and bonds could have mitigated their downside considerably. Sure, most asset classes plunged in the back half of 2008 amid the global deleveraging crisis. However, lest we forget, in a monumental "flight to safety" we saw a rally of epic proportions in U.S. Treasuries.

We hope that most of the $35 billion in new assets that flowed into fixed-income exchange-traded funds in 2009 were not just chasing performance. But, considering what we know about general investor behavior, it's probably not too far off to conclude that fear and panicked buying also likely helped fuel the massive inflows into bond ETFs and mutual funds last year. (In 2009, fixed-income funds accounted for $357 billion of the $377 billion in total net inflows into open-end mutual funds). Over the course of the year many ETF providers also rolled out new products to match the growing demand for bond funds.

Now, as the lurking risks of bond investments make headlines, some are speculating that flows could slosh back out of bond ETFs and mutual funds in search of higher returns elsewhere. In our view, rather than trying to time the market, investors would be much better off in the long run by thinking about their fixed-income exposures as part of a long-term asset-allocation strategy.

Along these lines, Gluskin Sheff economist David Rosenberg argues that the current divergence between flows into equity and fixed-income funds could persist for some time because of what he calls "secular change in behavior." In a Dec. 1, 2009, report, Rosenberg cited that less than 7% of household assets were in bonds, 25% were in equities, and 30% were in real estate. With aging demographics serving as a tail wind, he believes that investors could continue shifting assets into bonds, further propelling the divergence in flows between stocks and bonds. To be clear, we offer Rosenberg's point-of-view solely as food for thought.

In any case, the huge flows into bond funds also lead us to think about the differences between owning a bond fund and owning individual fixed-income securities. Of course, investors who are just temporarily parking assets in the bond market should find that ETFs' superior liquidity makes them the preferable vehicle. The stickier assets that flocked to bonds with asset allocation and long-term investing goals in mind, however, should be aware of the pros and cons between owning a bond versus owning a bond ETF.

Consider this: When an ETF invests in stocks, those stocks retain their equity market characteristics. However, a passive bond index ETF is a much different animal than say, owning any one of its underlying bonds individually. Bonds in an ETF no longer look or act like bonds. Simply put, bonds have maturity dates, whereas indexed bond investments do not. Remember, the interest-rate risk of an individual bond will decrease as it approaches maturity. A bond ETF, on the other hand, exhibits constant interest-rate risk. With interest-rate risk at the top of mind, this can be a critical point to consider for investors.

An example might help drive this point home. It is common practice for many to invest in laddered bond portfolios designed with specific maturities. This makes a ton of sense for those planning for a major event (such as a child's college education) and who plan to hold until expiration and collect par on their investment (this is commonly referred to as a liability driven investment). Price swings caused by movements in interest rates might be of little concern to such investors who know they'll receive par on their investment at maturity, as long as the creditor remains solvent.

Although the ETF research team can sometimes have a bias toward the ETF structure, we openly concede that there are investment scenarios that often favor other structures. As we've previously suggested in Morningstar ETFInvestor, we think that, in many cases, bond ETFs are most suitable as complementary players in an investor's bond allocation, perhaps between 10% and 30% of the total bond allocation. The remaining fixed-income allocation, for instance, could be a laddered portfolio of individual bonds with specifically tailored maturities designed to offset a given individual's future liabilities.

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