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Long and Junk Bond ETFs: Stepchildren of Fixed Income Investing

by: Ray Hendon January 04, 2008 | about stocks: BLV / HYG / IEF / JNK / PHB / PLW / TLH / TLO / TLT    

Ray Hendon

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Having gone through short, intermediate-term bond ETFs, and TIPS, it is now the turn of long term and junk ETFs. I will repeat my earlier prejudice about long term bonds—leave it to the institutional investors. Their volatility is too high to be appropriate for most individual investors. Plus, as you can see from Table 1 below, the investor is not rewarded in terms of dividend yield for taking on the increased volatility (click both tables to enlarge).

The ETFs listed in Table 1 are:

Table 1

Long-Term ETFs

You can see the popularity of pure Treasury holdings in long-term ETFs. Part of the reason is that institutional investors are the primary buyers of long-term obligations, and many of them are constrained by their own charters to stay with Treasuries. Another reason is that corporate bonds of this length are usually callable, which makes them unsuitable for many institutional portfolios, given the reinvestment risks a callable brings to the table, not to mention an unstable average duration.

Vanguard does not respect this tradition, as you can see from its holdings of about 50%/50% Treasury/Corporate. You can also observe the effects on its dividend yield; 5.39% is almost a full 100 basis points above the other ETFs. Given the age of this ETF (established 5/23/07) it has done well in attracting assets, already over half way to the $100 million mark. But, with an average duration of 11.3 you almost double the price fluctuations over that of Vanguard’s intermediate-term ETF. For me, this is not a tradeoff I would make, but every individual has his or her own preferences for risks.

One other point with respect to Vanguard: the large number of holdings is more necessary for their ETF, given that it mixes corporate bonds with Treasuries. Treasuries are consider safe enough not the have to worry about diversifying the risks. This is not true for corporate bonds, however. It would be a serious mistake for individual investors to hold a significant amount of their assets in one or two corporate issues. You take on too much business risks by doing this. And the only way to reduce the risk and still invest in corporate issues is to spread the risk over a large number of holdings. That is one of the features I discussed last time in intermediates. By owning the entire market, which the Lehman Aggregate Bond Index does ( more of less), you can have corporate issues in you holdings and still be properly diversified.

The ETF of PowerShares, PLW, is also interesting in its makeup. It emulates an advisor’s recommendation to ladder a bond portfolio. For an individual holder this means that you divide your bonds into, say, five categories. One-fifth in 1 year obligations, one-fifth in 2-year, and on out the ladder to one-fifth in 5 Year bonds. At the end of each year, you simply takes the money from the maturing one-year bonds and buy a new five-year. This keeps the duration about the same, year-over-year, and simplifies construction of your fixed income portfolio. It also has the advantage of keeping your bond portfolio current with respect to interest rates, so you are, more or less, indifferent to interest rate risks.

For individual investors this strategy does require a fairly hearty sum to implement, since buying bonds on the secondary market always incurs brokerage commissions so large as to preclude small ladders of, say, $10,000 --$2000 per rung of the ladder. Commission costs would simply be too much. The old rule of thumb for a ladder is about $100,000 at minimum. Now, with PowerShares, you can do it with an ETF.

This is an interesting innovation, and I am curious about how successful it will be. For now, it’s too early to tell, since this ETF was established in early October of last year.

The final category of bond ETFs I will cover today is one of great controversy. High yield, commonly referred to as Junk, has split the advisor community. Some advisors, whom I deeply respect, insist that junk holdings have equity-like risks (unstable average durations because of the risks of default) and therefore do not belong in the fixed income allocation of an individual investor. On the other hand, others whom I also respect, recommend a fairly high allocation of one’s fixed income holdings to this category. They think holding junk over a long time is ok, and the higher income produced by the spread is worth the volatility one gets with this class of bonds.

As for me, I fall back to one of the securest tenets of Modern Portfolio Theory, take only those risks you need to take and can afford to take. So, if your income needs require you to take a higher level of fixed income risks, and you can afford to volatility that comes with it, then take your chances. Overall I would prefer not to take the risks associated with high yield, unless the yield spread is enough to compensate for it. Often, this is not the case, in my view, but at times it may be, depending on your own needs and preferences.

Being warned, Table 2 covers the field of domestic high yield.

Here is the list of ETFs in Table 2:

Table 2: High Yield Bond ETFs

In this category of investment vehicles, mutual funds still have a substantial edge over ETFs on the number of offerings and a better cross section of quality. Oddly enough, among mutual funds, there are high variations of quality among the junk providers. Vanguard has what is considered the highest quality, and it falls off substantially from there.

Among the ETFs, all those in Table 2 began operation in 2007: iShares in April, SSgA November 28, and PowerShares November 15. None of them have a track record that gives us any historical perspective. They all hue to the middle of the yield curve, with SSgA and PowerShares being about a six months more venturesome. But, with the average duration of these instruments so volatile, you can’t count on them staying the same. With a default of two, average duration will change considerably.

I am sure all interested readers have noticed that I have omitted mention of municipal and international bond ETFs. This was planned. Munis have a unique market, and it is one that I have not studied sufficiently to warrant any comment. And there are only two states (California and New York) that have state-specific ETFs traded.

As far as international, I have used emerging market debt in the past as part of a bet I was willing to make against the dollar. But, for now, I think much of that play is over, so I’m staying clear of this field because of its extreme volatility. For me, taking on the extra political, currency and business risks of emerging markets must be rewarded with a substantial premium in yield. For the last few years this premium has not been high enough for my taste, so I don’t see it as a compelling alternative for now.

In terms of high quality international ETFs, there are some now appearing for sale in the U.S. But my take on international debt is that the costs of currency conversion and the higher cost of acquiring foreign debt with dollars, is high. This, to me, erases much if not all any short-term advantage foreign debt has over U.S. Treasury yields—when it does have an advantage. Also, with mutual funds, some international bond funds hedge the currency risk, and some don’t. To me, part of the reason to hold international obligations is for the currency risk exposure. So, if it is hedged away two things occur: you are left without exposure to a risk area that could add a healthy diversification to your portfolio, and you have to pay for the hedging, which further reduces the net yield.

I may be wrong on this issue, too. But, so far, I haven’t seen any evidence that convinces me that it is worth the expense and risk. The only exception I would make would be for those who are using un-hedged foreign bond ETFs or mutual funds to make a currency play. But, that introduces a level of speculation that many investors are uncomfortable with. If you want to play in those waters, good luck. There have been great fortunes made in this arena, and there have been great fortunes lost.

This concludes my comments on fixed income ETFs. I will return to the topic in the future for some additional information as this new part of the industry matures, and I plan on doing one article on suggestions about allocating fixed income holdings with ETFs. I hope you have found these discussions helpful in constructing your own fixed income portfolios.



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This article has 3 comments:

  •  
    Jan 08 02:20 AM
    Excellent thoughts, probably because I agree with most of your ideas. While I no longer use junk bonds, I do use iShares 1-3 year Treasuries (SHY), Vanguard Total Bond (BND) and SPDR Lehman International Treasury Bond (BWX). 10 years ago I read an interesting white paper by Dimensional Fund Advisors (DFA) that claimed all bond holdings should be placed in 1-year Treasuries with the rest commited to equities. It makes sense from a portfolio protection perspective as well as increasing returns in upward markets. I wonder if that concept still isn't valid today. I'd love to see new research on that topic.
    Reply
  •  
    Jan 08 02:30 PM
    Indexor:
    Thanks for your comments and kind words. Personally I think the short and intermediate ETFs you hold are about right. With BND you do go out the yield curve a little, but you also get rewarded a couple of points of yield for doing it. If you can stick with it during periods of rising interest rates, then you will maximize your dividend income and probably keep ahead of inflation.

    I'm not completely in agreement with the 1-Y T idea. It condems the holder to a low yield, and at times will not keep up with inflation. To me, the weak spot for Dimensional Funds is on fixed income. I may be wroing, but I don't think they have very good imagination on fixed income products. On the other hand, there is always some good in being conservative in your holdings.

    There is validity on their take on this subject, but validity depends much on the needs of the individual investor. It may be true for some, but not the best idea for others, depending on their personal situation. I certainly do not like it as a blanket prescription.

    Best wishes,

    Ray
    Reply
  •  
    Aug 06 11:49 AM
    Good News For Income Investors

    Looking for good news in today's markets is like searching for the proverbial needle in a haystack. Needless to say, practically all investment grade equities and nearly all closed end funds that specialize in providing regular recurring monthly income have been reduced in market value by this prolonged correction. The quake has spread in all directions from its financial epicenter, and the mounting doom and gloom has taken its toll on even the most rational investment decision makers. Try to keep in mind that the purpose of income investing is the income that your portfolio produces not an increase in the securities' market values---

    So here's the good news (and for anyone with a 40% or higher income asset allocation, or an income portfolio being used for living expenses), it really is very good news. Base income levels, from the beginning of the stock market correction in June '07 until mid-July '08, have barely changed at all. In fact, they have probably risen in properly asset allocated portfolios. I have examined the regular recurring monthly income distributed by 56 taxable income CEFs and 61 tax-free income CEFs, and the conclusions are pretty remarkable.

    In spite of the fact that the vast majority of my favorite monthly income producers are lower in market value than I would like, the amount of income they are distributing to shareholders has not moved lower meaningfully--- even though the Federal Reserve has reduced interest rates by approximately 60% during the past twelve months. Here are the numbers: (1) 48% of the taxable-income CEFs are distributing precisely the same amount per share as they did a year ago. Fourteen issues have increased their payouts and fifteen have reduced them.

    The net result is a decrease of just fourteen cents (2.5% of the total monthly payout). The average current yield on the portfolio, as of mid July '07, is 9.86% without considering any capital gains distributions. Additionally, the group is selling at market prices that reflect an average discount of nearly 11% from NAV. Is that special or what? The bonds, preferred stocks, government securities are priced 11% below their current market values.

    (2) The numbers are similar with regard to the 61 tax-free income CEFs: 46% have not altered their payout over the past twelve months; eighteen have reduced their payout slightly, and 15 have increased the monthly dole. The net difference for the group over the past year is less than one cent, or a percentage change of two-tenths of one percent. Remarkable. This group is selling at an average discount from NAV of 9.1% and has a current tax-free yield of 5.51%.

    (3) Of 117 individual issues, about half have produced stable income. The others have accounted for a total payout reduction of less than 15 cents--- a measly 1.7%. Why is this amount of little consequence? Two reasons really.

    First of all, a properly asset-allocated income portfolio does not disburse all of the base income it receives, so there is income available to reinvest in more shares of income producing securities. This process assures a growing cash flow to calm your fear of rising prices. The other reason is a bit more hypothetical. The Fed has lowered rates significantly, a process that normally produces higher prices for income securities. Eventually, those lower interest rates (even if global pressures convince politicians to take back some of the reductions) should produce higher prices (i.e., profit taking opportunities) in these securities.

    Admittedly, even if your asset allocation has been fine tuned for years, lower portfolio market values in this area make stock market valuation shrinkage feel even worse. But the value of stable cash flow becomes painfully clear for investors who misguidedly depend on capital gains for their spending money. Properly asset allocated portfolios contain enough base income generators to pay the bills. The purpose of capital gains is to produce proportionately more base income generators.

    The purpose of this email is simply to bring some needed sunlight into an investment environment that is far gloomier than I think it needs to be. If you want the details, you'll have to request them personally.


    Steve Selengut
    www.sancoservices.com
    www.kiawahgolfinvestme.../
    Professional Portfolio Management since 1979
    Author of: "The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read", and "A Millionaire's Secret Investment Strategy"
    Reply
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