Five ETFs With Low Interest-Rate Risk and High Yield

Note: This article originally ran on April 6, but in case you missed it, we are re-featuring it as part of Morningstar.com's ETF Investing Week.

Although far from great, the U.S. economy has shown steady signs of improvement over the past few months. In fact, we have witnessed six consecutive quarters of positive GDP growth. The unemployment rate has started dropping from a high of 10.1% in October 2009 to 8.8% today. The current positive momentum means that we are getting closer to the Federal Reserve raising short-term interest rates and stopping the open-market purchases of Treasury bonds. When this happens, interest rates of all maturities are expected to rise. Because bond prices are inversely correlated with the direction of interest rates, a portfolio of fixed-income securities will likely lose value. What can bond investors do to insulate their portfolios from principal losses?

To help insulate a portfolio from rising interest rates, an investor can look for bonds that have above-average yield and below-average duration. Bonds with higher relative yields are less affected by movements in short-term interest rates. Duration is a measure of a bond's price sensitivity to interest-rate movements, and it allows an investor to compare bonds with different maturities and coupons. For every 1% rise in interest rates, the bond's value will decline by its duration. For example, a bond with a duration of 5.0 years will decline approximately 5% with a 1% rise in interest rates.

The standard benchmark for fixed income is the Barclays Aggregate Bond Index. It currently has a duration of 5.1 years and a yield to maturity of 3.0%. The following is a list of fixed-income exchange-traded funds with above-average yield and below-average duration.

Keep in mind that these alternatives are different animals from the benchmark. Bond investing is all about weighing which risks you want to take, and these suggestions reduce interest-rate risk but add credit risk, foreign currency risk, and prepayment risk to the table.

 WisdomTree Emerging Markets Local Debt (ELD)
Yield to maturity: 6.1%
Duration: 4.8 years

ELD is an active fund that offers exposure to government bonds of emerging-markets countries denominated in their local currency. Emerging-markets debt has historically been very volatile and prone to defaults. In the past, most debt was issued in U.S. dollars because they did not have local debt markets. This exposed them to the volatile swings of their currency in comparison to the U.S. dollar. In the past 10 years, emerging countries have worked to reduce their reliance on external funding. The growing private pension systems, higher savings rates, sound fiscal policies, and more-flexible currency regimes have created internal demand for the emerging countries' government debt.

With an average credit rating of BBB, this fund sports an investment-grade portfolio with a yield of 3%, which is better than the benchmark. Also, its duration is slightly lower than our benchmark. The returns of the fund will be strongly impacted on the direction of the U.S. dollar in relation to the emerging markets. While short-term currency movements are uncertain, the longer-term trend seems to indicate a declining dollar versus emerging currencies because of the emerging markets' higher GDP growth rates and strong sovereign balance sheets.

PowerShares Fundamental High Yield Corporate Bond (PHB)
Yield to maturity: 5.97%
Duration: 4.19 years

PHB is a high-yield bond ETF that takes a slightly different approach than the typical bond fund. Most bond indexes weight their holdings by size of issuance. So, a heavily indebted firm like CIT Group  gets a larger weighting in the index than a less indebted firm. Conversely, PHB weights its holdings by fundamental factors such as sales, cash flow, book value of assets, and dividends with the goal of holding an increased weighting in firms most likely to repay their debt. The result of this weighting methodology is a higher-quality portfolio with an average credit quality of BB. The average high-yield bond fund holds about 17% of assets in bonds rated CCC or lower, whereas PHB has a 0% weighting in these lower-quality bonds. If the economy keeps improving, the additional credit risk of PHB shouldn't be a negative. However, if the economy falters, defaults could rise and returns could suffer.

 iShares Barclays Intermediate Credit Bond (CIU)
Yield to maturity: 3.2%
Duration: 4.2 years

CIU focuses on investment-grade credit bonds with an average credit quality of BBB. The underlying fundamentals of U.S. corporations have been steadily improving. Companies have reduced debt, refinanced loans at lower interest rates, and seen their earnings improve. With companies' improved balance sheets, the income from CIU appears to be on steadier ground. Corporate credit spreads have tightened considerably, so this fund does not have the yield advantage it once had, but it still could be a desirable option.

PowerShares Senior Loan Portfolio (BKLN)
Yield to maturity: 4.7%
Duration: near 0 years

BKLN tracks a portfolio of senior floating-rate bank loans with an average credit quality of B. Bank loans are unique because their interest rates adjust every 30 to 90 days. This adjustment makes them very desirable in a rising interest-rate environment because they have almost no interest-rate risk. Companies that issue floating-rate debt do so because fixed-rate debt would be too expensive. While there is definitely increased credit risk, the bank loans are fully collateralized with real estate, inventory, equipment, or other assets. This collateral protection has led to a historical recovery rate of 66%, compared with about 37% for traditional high-yield bonds, according to Moody's. With an above-average yield and a duration near 0 years, bank loans are one of the best investments in a rising interest-rate environment, but if economic conditions worsen, the ETF's high credit risk will be a negative for returns.

 iShares Barclays MBS Bond (MBB)
Yield to maturity: 3.12%
Duration: 3.6 years

MBB owns a very high-quality mortgage-bond portfolio. The underlying bonds are issued by Fannie Mae and Ginnie Mae, which, after the financial crisis of 2008, have the backing of 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.

Mortgage bonds are exposed to two types of risk, prepayment risk and extension risk. Prepayment risk is the ability for homeowners to refinance or sell their home at any time. This makes mortgage-bond cash flows very unpredictable. The bonds pay higher interest rates because of the increased uncertainty of when you will actually receive your principal back. Extension risk is the risk that rising rates will slow the assumed prepayment speeds of mortgage loans, delaying the return of principal and increasing the duration. If people can't sell their homes and stay longer, a mortgage-bond fund could see its duration rise, which would increase its interest-rate risk. 

 

		ETFInvestor Newsletter
	Let our new newsletter, Morningstar ETFInvestor, help you navigate the exciting and new world of exchange-traded funds. Each issue includes recommendations for commonsense ETF investing,		ETF spotlights, and critical data on 150 top ETFs. This one-year subscription consists of 12 monthly issues. Download a free issue today.
	$185.00 for 12 Print Issues		$175 for 12 PDF Issues

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock Asset Management, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.