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By Paul Justice, CFA | 06-16-2010 11:46 AM

Building a Laddered Bond Portfolio with ETFs

New corporate bond ETFs with set maturity dates could allow sophisticated ETF bond investors to better match their investments with their liabilities.

Paul Justice: Low yields have investors clamoring for ways to find income in their portfolios these days. I'm Paul Justice, Director of ETF Research for North America at Morningstar. Today, I am joined by Steve Baffico, Managing Director over at Claymore Securities. Thank you for joining me.

Steven Baffico: Paul, pleasure to be here. Thanks for having me.

Justice: You launched an interesting product here this week with a concept called BulletShares, which I think is going to pick up some steam in the ETF industry. Could you talk a little bit about this product and why it can help investors build a little bit more yield from what a paltry treasury yield are giving them?

Baffico: Right. Sure, we're very excited about the BulletShares launch this week. It's a series of funds with defined maturities, ranging anywhere between one and seven years, focusing on baskets of corporate bonds. I think the larger question to ask Paul is, really, how investors effectively manufacture returns and manage risk in the fixed income markets today, particularly in the United States when we think about the drastically changed composition of the Barclays Agg.

Justice: Right, which is an index that many people use to build their ETFs off of, which is largely constituted of very low yielding treasuries right now.

Baffico: Sure. Given what's happened in the last several years and the need for government intervention in the markets and significant influence in the Barclays Agg as a result, so what we see today is a aggregate index, which is nearly 80% or more government related assets. And I think what that means to investors is, it's a U.S. market that is low vol and low return. So the other 20% of that market, the credit markets or spread assets, become highly consequential to manufacturing those liability-driven type returns, investors expect the need.

We think that BulletShares is one of those applications that help more effectively navigate that 20% of the market that you have to own, that tends to be in this kind of post credit crisis era more difficult to navigate, difficult to create diversification, find inventory, price execution, transparency. So it's a more highly sophisticated market that is more consequential to the clients' portfolio, but more difficult to access.

Justice: Sure. It's a bit more complicated, but the name implies some simplicity, and it indicates the people when they are taking on risk assets, how far out that maturity is going to go. The shorter the maturity, the less duration or interest rate risk that you are going to face. So this is a good compliment to add if you already own exposure to the Lehman Agg Index.

Baffico: Sure. So, most investors are familiar with the concept of laddering bonds, a way of staggering maturities to achieve returns, but also to manage interest rate and credit risk frankly in a portfolio. So what BulletShares conceptually seeks to deliver to the client is the ability to ladder ETFs in this case, which have defined maturities. But also represent underneath them a diversified basket of corporate bonds and giving the investor the benefit of really a surgical precision with which they can address those, let's say, liability-driven needs, future life events or the diversification benefits that laddering provides through a basket of bonds across a number or series of finite maturities within the BulletShares themselves. So it really gives you the ability to custom build a portfolio of corporate bonds with finite maturities and giving you all the benefits that package products certainly generally offer.

Justice: Sure. So if I was buying an individual bond with the maturity date, say, of 2013, I am exposing myself to risk from company-specific problems, I am not getting the diversification with the ETF. I still get that maturity date, but I have got exposure to more bonds.

Baffico: Sure, just like we talked about the changing landscape of the U.S. market, so too really in the way that we think about managing risk and security selection. So creating diversification and the difference between security A versus security B, really probably more consequential than it's ever been in the fixed income markets.

I think one of the chief benefits that the BulletShares offer is that, at various inflection points on the yield curve it gives you a very well diversified proxy for those maturities and does so in a fashion, whose duration is constantly winding down as the fund gets closer to its stated termination or liquidation date.

Justice: Sure. Closer to expiration my risk is going down, which makes it also an effective means for liability matching, if I have some sort of targeted event occurring at that year – at that point in time.

Baffico: Sure. I think just as we've talked about the benefits of laddering from a risk management standpoint or interest rate management, we think one of the chief benefits and it's certainly a challenge that clients have is creating a portfolio that provides more of a customized approach to future life events.

Let's say, you might have a college tuition payment in five years that you have to make, you've got anticipated retirement expenses. Being able to express that through something like a BulletShares' concept really allows you to custom build the portfolio that we think helps better anticipate or meet those needs in future life events. So it is a chief benefit that we think gives you the precision tools through the BulletShares to accomplish that more effectively.

Justice: Well, I think it's a great concept, and somebody who is a bit more sophisticated in their bond portfolio management should probably take a look at these products. So, thank you for joining me Steve.

Baffico: Great. Thank you very much.

 

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