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Bond Investors, Undervalued ETFs, Frontier Markets, and More

A roundup of investment news from Morningstar Advisor magazine.

Morningstar Analysts, 07/12/2010

Are Bond Investors Too Late to the Party?
Investors need to select a healthy blend of asset classes in order to maintain portfolio income, lower risk, and outpace inflation, according to Morningstar research and communications manager Jim Licato. Fixed- income securities were relied upon rather heavily during the latest crisis as investors fled riskier alternatives. Prices were pushed up as a result, and yields fell sharply. However, yields, which have recently hit historical lows, will eventually start to move upward. Consequently, bond investors will then have to contend with falling prices because of the inverse relationship between prices and yields. Just how low will bond prices fall, and how much will the total returns of these investments suffer as a result?

A bond's riskiness and performance potential are closely tied to its maturity. The longer a bond's maturity, the more volatile its price when interest rates rise or fall. Historically, shorter maturity bonds have been relatively insensitive to movements in interest rates, dropping an average of 1.3% when interest rates have risen and gaining an average of 1.4% when interest rates have fallen. (Analysis covers the time period January 1970 to December 2009.) Bonds with longer maturities have been the most sensitive, dropping by an average of 8.3% when interest rates have risen and gaining an average of 9.7% when interest rates have fallen.

Bonds have historically experienced return fluctuations just as many other asset classes have. The image below illustrates the range of returns for different bond funds from 1985- 2009. During this time period, high-yield and long-term fund categories had the greatest upside potential but with more risk than their short- and intermediate-term bond-fund counterparts. As was mentioned earlier, long-term bonds offer higher rates of interest to compensate investors for risks associated with longer maturities.

While bonds may be losing their luster as the stock market has rallied of late, it is important to convey to your clients that while prices of bonds may be heading south in the near future, this investment vehicle can still be relied upon as a source of income and diversification. It wasn't too long ago that stock investors, while suffering through one of the worst bear markets in history, wished they had a considerable amount of their wealth in the fixed-income market to help lessen the pain.

(View the related graphic here.)

Five Undervalued ETFs to Let Run
Morningstar's ETF analysts recently ran a screen searching for ETFs that both have outperformed the domestic large-cap market over the past year and are still undervalued relative to the market. Here are five such funds that, if they already owned them, the analysts wouldn't part ways with just yet. (A price/ fair value of 1.0 means the security is fairly valued; anything under 1.0 is undervalued.)

iShares MSCI EAFE Index EFA
One-Year Return: 42.2%
Price/Fair Value: 0.87
This fund is the biggest and best-known ETF tracking the most established foreign large-cap index around, and it is still one of the best choices for a core foreign-stock holding. PAGEBREAK

iShares MSCI Canada Index EWC
One-Year Return: 52.8%
Price/Fair Value: 0.95
This single-country fund has a strong cyclical orientation. The top three sectors include financials (which accounts for 35% of the portfolio), energy (27%), and materials (19%). Risk-averse investors should note that this fund has a high exposure to commodities through its holdings in oil producers and gold miners.

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