Getting a Fix on Fixed-Income ETFs

The menu of bond ETFs has expanded exponentially in 2007. When 2007 began, investors had six fixed-income ETFs to choose from. Now there are 52 bond ETFs in our database, and more are on the way.

Take a Broad, Diversified Approach
To a large degree, ETF providers have approached the bond market in much the same way that they have other market segments--by slicing and dicing. Many of the domestic bond funds launched this year divide the market into various maturity ranges. Now, choices vary from an ETF that focuses on one- to three-month Treasury bills to one that invests in 10- and 30-year Treasury bonds.

I'm sure some investors will attempt to use these narrow ETFs to make bets on the direction of interest rates. But I'd urge you to avoid that temptation. It can be very difficult to accurately time interest-rate swings. That's why our favorite bond managers rarely make big interest-rate calls. The risks can be noteworthy, but the payoff is typically slim.

Stretching for yield by investing in long-term bonds has a similarly unattractive risk-reward profile. Yes, you'll earn a bit more on a long-term fund, but you'll put up with more ups and downs, and volatility is not what most investors want from their core bond fund. The average long-term bond fund returned 5.4% per year on average over the past decade, while the average intermediate-term bond fund returned 5.0%. But the long-term bond fund experienced almost twice as much volatility, as measured by standard deviation of returns. What's more, long-term bonds experience sharper pullbacks when interest rates increase. When rates rose in 1999, the Morningstar Long-Term Core Bond Index declined 7.5% for the year, while the Morningstar Intermediate-Term Core Bond Index lost just 1.3%.

That's why I think most investors are better off keeping most of their fixed-income allocation in a low-cost, broadly diversified intermediate-term bond fund. Most offer respectable returns and at the same time serve as ballast for your portfolio. The best core bond ETF, in my opinion, is Vanguard Total Bond Market ETF (BND). It tracks the Lehman Brothers Aggregate Bond Index. The Lehman Agg, as it's called in investing circles, serves as the ubiquitous reference point in the bond market, in much the same way as the S&P 500 Index does in the equity arena. Barclays and State Street each offer ETFs that track the Lehman Agg, but the Vanguard fund edges out its two rivals for two primary reasons.

First of all, it's cheaper, but just barely. With an expense ratio of just 0.11%, it boasts the lowest fees of all diversified bond funds available to retail investors. It's less expensive than its chief ETF competitors, SPDR Lehman Aggregate Bond (LAG) and iShares Lehman Aggregate Bond (AGG), which charge fees of 0.13% and 0.24%, respectively.

Secondly, its unique structure allows it to hold a more diversified portfolio of bonds. To explain why I'll have to get a little technical, so bear with me.

The Lehman Agg holds thousands of individual securities. Consequently, it's impossible for index funds and ETFs to hold all the securities in the benchmark. Instead, they hold a representative basket of securities that mimics the characteristic of the index. iShares Lehman Aggregate Bond and SPDR Lehman Aggregate Bond each own less than 200 bonds. They need to hold more compact portfolios to make in-kind trades with authorized participants possible. (As a reminder, authorized participants are big institutional investors that trade directly with the ETF. They are at the center of the in-kind creation/redemption process designed to keep an ETF's market price and net asset value in close proximity.)

Unlike the other ETFs, Vanguard ETFs are structured as separate share classes of index mutual funds that already exist. Thus, Vanguard Total Bond Market ETF offers exposure to the same portfolio of over 3,000 bonds that  Vanguard Total Bond Market Index (VBMFX) does. The ETF use a smaller subset of the fund to support in-kind creations and redemptions with authorized participants.

While this all might seem a bit esoteric, it has real implications for the behavior of these funds. Specifically, diversification spreads out risks, and most investors want their core fixed-income holding to keep risks in check. In addition, because the Vanguard ETF holds more securities, I think it will have a better shot at tracking its benchmark more closely.

To be fair, iShares Lehman Aggregate has done a respectable job of aping the index. Over the past three years, the underlying index has produced average annual returns of 4.46%, while iShares Lehman Aggregate has returned 4.29%. However, Vanguard Total Bond Market Index Fund, which had the same expense hurdle as the iShares ETF, fared even better, posting returns of 4.39%.

Municipal Bond ETFs
Muni ETFs hit the market just a few months ago. They bring a major advantage to the table--low costs. That's powerful in muni land because expenses eat up a large portion of the modest total returns generated by the typical muni fund. SPDR Lehman Municipal Bond (TFI), iShares S&P National Municipal Bond (MUB), PowerShares Insured National Muni Bond (PZA), and Market Vectors Lehman AMT-Free Intermediate Muni (ITM) charge 0.20%, 0.25%, 0.28%, and 0.20%, respectively.

Even so, these ETFs aren't the cheapest way for retail investors to gain muni exposure.  Vanguard Intermediate-Term Tax Exempt Fund (VWITX) is cheaper than all the ETF options, with an expense ratio of 0.17%, and you don't have to pay a brokerage commission to invest in it. Plus, it's far more diversified. It holds more than 1,300 individual securities, compared with an average of about 60 securities for the ETFs. So I think the Vanguard fund is a justifiable alternative to all of the muni ETFs currently on the market.

Furthermore, I think there is reason to take a wait-and-see approach to muni ETFs. Most muni investors tend to be buy-and-hold types, so trading is modest in the secondary market. That could pose liquidity problems, which could cause the ETF's market prices to stray from their net asset values. It could also have implications for the bid-ask spreads for these ETFs. They are still too new to see any meaningful trends in this regard. Finally, like their taxable counterparts, muni ETFs also tend to be less diversified than competing actively managed funds. So I don't see the need to jump in until we get a better sense of how these funds behave over time, particularly when there are attractive conventional alternatives.

Supplemental Bond ETFs
As the bond landscape has grown, more wide-ranging options are available to investors, including TIPS, high-yield funds, and international bonds. Of these supplemental offerings, I think TIPS hold the most promise. I think it makes sense to add some inflation protection to your bond allocation via a TIPS fund. The TIPS market is very efficient and not terribly complex, so a low-cost indexing approach works well. SPDR Barclays Capital TIPS (IPE) is the cheapest TIPS fund available at 0.18% (unless you have access to the Admiral share class of Vanguard Inflation-Protected Securities (VAIPX), which requires that you have at least $100,000 invested at Vanguard or $50,000 if you've had an account with Vanguard for at least 10 years.)

I'm skeptical of high-yield ETFs. I think active junk bond managers have the potential to add value through careful security selection and credit analysis. I generally have the same thought when it comes to international bond ETFs, particularly those that focus on emerging markets. Active managers in those market segments can steer clear of overheated or overleveraged countries or those exposed to more political risk and emphasize those regions that are more financially solid and primed for growth. They bring vast institutional resources to the task of making these calls. 

 A version of this article ran in the December 2007 issue of Morningstar ETFInvestor.

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