Many Flavors of Bond ETFs

Stocks are definitely the most popular asset class covered by exchange-traded funds (ETFs), but you can buy a lot of other things, too. For instance, did you know you can invest in the bond market with ETFs?

You might respond that bonds are too boring, or too tame, or too risky. Yet the fact is, you can’t really make these sorts of blanket statements about bonds — because not all bonds are alike. Some are very safe … some are very risky … and some can be downright exciting!

Today I’m going to give you a quick overview of the major bond ETF categories. Whatever your goals may be, I bet you’ll find something in this story to help you.

Before we go any further, though, let’s think about why you would even need a bond ETF. The answer is that buying individual bonds can be expensive and bothersome. Brokers are not always familiar with them, while small orders (and “small” in this context means “less than millions of dollars”) usually have higher transaction costs.

With bond ETFs, your money is part of a big pool that tracks an index of individual bonds. This keeps costs down. It also makes bond ETFs as easy to trade as stocks or stock-based ETFs — and they come in many flavors.

Let’s take a look …

Treasury Bond ETFs:
As Safe as Uncle Sam

When you buy bonds, you’re lending your money to the issuer. If the issuer defaults, you lose. This is called “credit risk.” And the best way to minimize credit risk is to lend your money only to issuers that are the least likely to go under.

Treasury bonds are fully backed by the U.S. government.

The U.S. Treasury is about as rock-solid as they come. If you buy Treasury bonds and hold them to maturity, the U.S. government guarantees that you’ll get back all of your principal plus interest.

How long this takes depends on which bonds you buy. You can get Treasury securities that mature in as few as four weeks or as long as 30 years. Normally the longer maturities pay a higher interest rate to compensate you for keeping your money tied up.

However, with bond funds (whether ETFs or traditional mutual funds), most of the bonds in the portfolio are not held to maturity. Instead, they’re constantly “rolled-over” to maintain the desired maturity of the fund. That way, when you buy a 10-year Treasury fund for example, you know that the average maturity of the portfolio will always be 10 years.

Here are a few of the most popular ETFs that cover the various Treasury maturities …

SPDR Barclays 1-3 Month T-Bill ETF (BIL)
iShares 3-7 Year Treasury Bond (IEI)
SPDR Long Term Treasury ETF (TLO)
PowerShares 1-30 Laddered Treasury Portfolio (PLW)

Corporate Bond ETFs:
Free Enterprise at Work

You can also get easy access to the corporate bond market with ETFs. However, in contrast to Treasury issues, corporates carry a greater degree of credit risk. They also tend to have higher yields.

How risky are corporate bonds? It depends on the ratings assigned by analysts at firms like Moody’s and S&P. Investment grade bonds are thought to be safer than others — but the analysts don’t always get it right.

This is another advantage of owning bonds through ETFs: You’re buying a diversified portfolio instead of just a single issue. So if one of the companies whose bonds are in the ETF goes out of business, you won’t face a big loss.

Here are some examples of corporate bond ETFs …

iShares iBoxx $ Investment Grade Corporate Bond (LQD)
iShares Barclays Credit Bond (CFT)
iShares Barclays Intermediate Credit Bond (CIU)

A special category of corporate bonds is called “high-yield” or “junk” bonds. These are from companies that are small or financially questionable. The interest rates can be very attractive but risks are higher. You can get them in ETF form, too, with funds like …

PowerShares High Yield Corporate Bond (PHB)
iShares iBoxx $ High Yield Corporate Bond (HYG)
SPDR High Yield Bond ETF (JNK)

Municipal Bond ETFs:
Tax-Free Income

If you’re like me, you hate to pay any more taxes than necessary. So municipal bonds might be for you. These are bonds issued by state and local governments, and the interest you get from them isn’t subject to federal income tax.

Typically, municipal bonds are issued to pay for capital projects like roads, schools, sewers, and parks. They’re considered to be riskier than U.S. Treasury bonds, but the tax-free income can be very attractive for those in higher tax brackets.

Muni bonds are an investment in local projects.

If you want to hold municipal bonds through an ETF, here are some of your choices …

iShares S&P National Municipal Bond (MUB)
Market Vectors — Intermediate Municipal Index ETF (ITM)
SPDR Barclays Short-Term Municipal Bond ETF (SHM)

International Bond ETFs:
Income from Around the World

Smart investors know they need to diversify outside the U.S. That’s just as true for your bond portfolio as it is for stocks. Once again, ETFs are a great tool.

When you buy an international bond ETF, you get both the interest payment and a currency adjustment back to the U.S. dollar. These currency adjustments can work either for you or against you. If the other currency rises against the dollar, your bonds will be worth more. If it loses ground, you might take a loss.

International bond ETFs offer a great way to diversify your portfolio.

Not all international bond ETFs are the same. Some focus on the more stable developed markets, while others specialize in emerging markets that haven’t yet proven themselves. If you see a really high yield, you can usually bet that the risk level is high, too.

Some of the top international bond ETFs are …

PowerShares Emerging Markets Sovereign Debt Portfolio (PCY)
SPDR International Treasury Bond ETF (BWX)
iShares JPMorgan USD Emerging Markets Bond Fund (EMB)

One Last Thing …

Bonds are usually thought of as income investments, and with good reason. Individuals and institutions buy them so they can get predictable interest payments.

Remember, though, that bonds and bond ETFs also have the potential for capital gains and losses. If interest rates shoot higher, the value of your bonds can take a hit. Likewise, you can get a nice bonus if interest rates fall.

Especially now, with the economy uncertain and stocks on dangerous ground, every investor needs to be aware of bond ETFs. Take a look at the ideas I’ve given you today. You may find at least one of them is a good fit for your portfolio.

Best wishes,

Ron

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