Seeking the Sweet Spot: Intermediate-Term ETFs

by: Ray Hendon December 28, 2007 | about stocks: AGG / BIV / BND / CIU / GVI / IEI / ITE / LAG / MBB    

Ray Hendon

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I’m going to limit this week’s subject to intermediate-term ETFs of investment grade quality rather than try to include long-term bonds and junk. To include these in the same article would make it much too long.Also, intermediates are generally the sweep spot of bond investing, so they deserve more explanation. Long-term and junk, I’ll leave for next time.

Bonds are simpler than sometimes thought. Their prices/yields respond primarilty to two things: the term of the bond (or average term of the bond fund) and the quality of the issue (or average quality of the bond fund).

For ETFs we can measure the term effects by looking at its average duration. The term effects are shown in the yield curve where longer maturing bonds usually have higher yields than short ones. See Graph 1, below.

For the quality ladder as you step down from the highest quality, which are Treasury obligations, to lower rungs of corporate debt, the yield increases. Technically, for each grade of bond, there would be a separate yield curve applicable. The one shown below is for Treasury bills, notes and bonds.

Along the yield curve there is usually a “sweet spot” where the risk/reward ratio is best for individual investors. This spot changes with the shape of the curve over time, but for much of the time it is likely to be in the intermediate term area. For this reason, intermediates are popular for individual investors, while long bonds are the principle providence of institutional investors. On Graph 1, where would you prefer to be with your fixed income holdings? There is no one correct answer to this question, by the way, it depends on your own preferences for risk and your own time line for holding your investments.

Graph 1

U.S Treasury Yield Curve

For me, at least recently, the sweet spot has actually been on the short side, so my fixed income portfolio is largely in money markets, short CDs, and short-term corporate bonds. The reason that the sweet spot has been short lately is that just a few months ago the yield curve was actually inverted. This is an oddity of bond pricing, where short-term yields are higher than long-term, and often precedes an economic recession. But, as you can see, above, the curve is already resuming a more normal shape.

The curve in Graph 1 clearly shows the recent effects of the Federal Reserve lowering short-term rates, anticipating at least an economic slow-down. This uncertainty makes it diffifult to identify a strong sweet spot at any one time. I suspect, though, that intermediate-term rates will continue to reclaim their traditional place as the sweet spot for fixed income investing, as short rates fall and longer-term rates adjust to new conditions of a slowing economy.

For now fixed income investors have a robust menu to choose from among intermediate-term ETFs. In Table 1 you can see that iShares offers five flavors of pure intermediates and one aggregate bond index (which grades out as intermediate); SSgA and Vanguard offer one each of the pure intermediates and one each of an aggregate bond index. Ameristock, too, has a couple of ETFs that fit this category, but for reasons I explained last time, I don’t have confidence that this firm’s offerings will be here next year, so I am not including them in today’s coverage.

Before jumping into Table 1, it will help if we refresh our memory about the quality ladder and the spreads that define the qualitative differences among bonds. At the top are U.S. Treasury obligations (bills, notes and bonds). For obvious reasons obligations of this class are considered the safest in the world, as the risk of default is thought to be lower than for any other debt obligation. Even AAA rated corporate bonds are not considered as safe as Treasuries, and investors demand a premium from the corporates to compensate for the lessened security. A 1% to 2.5% spread over Treasuries is not unusual for corporate issues. On December 24, the 10Y T yield was 4.21% and the 10Y AAA Corporate was 5.2%--a fairly narrow spread.

Furthermore, AAA Government Agency issues such as Ginnie Maes, Freddic Macs, etc. are not as desirable as Treasuries, and pay something of a premium yield to compensate the investor. These obligations are referred to as mortgage backed securities [MBS], and they always yield more than Treasuries, partially because of their unstable average duration. Since you can't forecast when a homeowner will prepay the mortgage and reduce the duration of the fund that holds it, one cannot compute the actual average duration. The bond fund managers try and estimate these prepayment figures, and they call the resultant calculation, "effective" duration, or "adjusted" duration. All in all, it simply means you can have no confidence in the number published, as it is subject to wide fluctuations as prepayemnts rise or fall with economic conditions.

A side note on this issue is how average duration figures are used in helping construct a fixed income portfolio. As we have discussed, the average duration is a good indicator of how far out the yield curve the ETF has ventured. But, there is a more precise use of this measurement: the average duration also predicts with great precision how the net asset value of the ETF will respond to changes in interest rates. Thus, a 1% rise in the intermediate-term interest rate will cause the ETF price to fall (price and interest rates always move in opposite directions) by the average duration multiplied by the interest rate change. So, if the average duration is four, then a 1% rise in interest rates will cause the NAV of the ETF to fall by 4%.

This measure of price volatility is what informs your willingness to venture out the yield curve in search of higher yields. An average duration of 15, for example, would cause the NAV to fall by 30% over a period of time when interest rates rose by 2%. This much volatility keeps individual investors more to the middle of the curve, looking for their sweep spot.

In Table 1, below, Treasury obligations will be denoted as T.

Treasury plus Agency obligations will be G (for Government),

Commercial bonds (investment grade only) will be C,

MBS is for mortgage backed securities.

Some ETFs have more than one class, so they will be designated as G/C, T/C e.g., as the case calls for.

Here are the full names of the intermediates found in Table 1 (click both tables to enlarge):

Table 1

Intermediate-Term ETFs

Table 2

Aggregate Bond Index ETFs

(All with a quality grade of G/C)

It is clear that the intermediates are doing well as far as attracting assets. Only two have failed to reach the $100 million plateau, the level at which mutual funds become generally profitable for the provider. I don’t know that this is any different for ETFs. You simply need a certain critical mass to keep administrative costs efficient.

Keep in mind, too, that three of the largest intermediate class ETFs are indexed to the Lehman Aggregate Bond Index, by far the most popular intermediate index for the general investor.

Two of the ETFs in Table 1 follow the Lehman Government/Credit Index: GBF and BIV. But, Vanguard, the manager of BIV, goes out the yield curve almost a year further than GBF. It gets about 20 basis points added to yield for one more year of average duration. Whether this increase in yield would satisify your desire for stability depends entirely on your own risk preferences. Not all investors have the same sweet spot!

For my purposes, I prefer the diversity of the aggregate index, since it holds some of about everything of investment grade quality, and you generally earn a slightly higher yield with this mixture. Note the yield of 4.96% by iShares’ Aggregate Bond Index. This is higher than any ETF in Table 1. This state is not unusual. The credit risks of the total bond market (which are still investment grade, but lower than AAA) are notably higher than AAA intermediates, so the owner should expect a higher payoff.

I hope this discussion will help you construct a fixed income portfolio that is most suitable for your needs. Next week I will cover the long-term instruments and junk.

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