“It’s very clear that the rate environment in the next 10 years won’t look like the last 10," says Leland Clemons, founder of ETF issuer BondBloxx Investment Management.
If that is the case, investors with portfolios that use bond funds for their fixed-income allocations might want to try using more-targeted exchange-traded funds to fine-tune those exposures.
Twin risks
Bonds and bond funds primarily carry two types of risk. The first is credit risk, or the likelihood that interest and principal won’t be repaid. This risk is generally expressed in the interest rate that investors are willing to accept. The better the credit, the lower the rate. S&P Global, Moody’s and Fitch assess the riskiness of debt issuances by assigning a credit rating from AAA/Aaa (stellar) to D (in default).
The second risk measurement is known as duration, which indicates the sensitivity of a bond or bond portfolio to movements in interest rates. Though measured in years, duration isn’t the same as maturity, or when the principal of a bond is paid back.
For bond funds and ETFs, average duration or effective duration is usually included on the fund website or at a third-party site such as Morningstar or ETF.com. Duration is useful for predicting how much a fund share price would move relative to a change in interest rates. A fund with a duration of 7 would be expected to fall 7% in response to a 1 percentage point increase in rates, or rise 7% in response to a 1 percentage point decrease in rates.
Mission creep
To start a bond portfolio, John Croke, head of active fixed-income-product management at Vanguard, suggests that an investor with a reasonably long time horizon—say, five to seven-plus years—invest in funds or ETFs that track the Agg, or Bloomberg US Aggregate Bond Index.
“Out of the box, the Agg gives you broad, diversified exposure to a liquid universe of U.S. fixed income across U.S. Treasurys, investment-grade corporates and agency mortgages," says Mr. Croke.
Duration on the Agg is currently around 6.5 years while yields on index funds tracking the index are roughly 4.2% to 4.4%.
Most bond indexes, however, are not static and risk levels can change based on the market. “Indexing in fixed income can concentrate risk and push investors out on the yield curve," says Tim Courtney, chief investment officer with Exencial Wealth Advisors in Oklahoma City. The tndency of companies to load up on inexpensive debt in recent years, for example, extended the duration and credit risk borne by investment-grade corporate debt index funds. Duration on the widely held $32 billion iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) increased to near 10 in 2020 and 2021, while the fund’s credit profile declined. Its duration is currently 8.25, it yields 5.9% and has an expense ratio of 0.14%. According to Morningstar, shares of LQD are down 21.3% this year through Nov. 1.
Term maturity
A different type of bond-fund product, called term or defined-maturity ETFs, reduces the interest-rate risk that investors face by offering them the ability to build bondlike ladders. Investors can ladder specific maturities of ETFs (from one to 10 years) that pay monthly income and return par value upon expiration, as opposed to traditional funds and ETFs which are perpetual products.
Offered as BulletShares by Invesco or iBonds by BlackRock’s iShares unit, the individual ETFs mature like traditional bonds and invest in U.S. Treasurys, municipal bonds, investment-grade and high-yield corporate bonds, as well as emerging-markets debt. Distributions are paid monthly, and par value is returned when the ETFs “mature." Depending on the availability of bonds in the asset class, investors can ladder the ETFs up to 10 years.
Capital gains (and losses) will depend on the price paid for the ETF shares on the open market relative to the per-share net asset value at maturity.
Targeted duration
Many index and actively managed funds have a target duration for their portfolio, putting up guardrails for how much interest-rate risk the portfolio manager (or index) is willing to take on. Still, duration could shift with the index that a fund tracks or with the whims of the fund manager. In September, BondBloxx launched eight target-duration ETFs for the U.S. Treasury market. From six months to 20 years, these ETFs give investors the ability to shape their own yield curve with expense ratios ranging from 0.03% for six months to 0.125% for 20 years.
Separately, earlier this year, F/m Investments launched the US Benchmark Series, which invests only in “on the run," or the most recently issued, U.S. Treasury securities across three months, two years and 10 years at expense ratios of 0.15%.
“Duration should always be lower than your time horizon," says Michael Furla, head of fixed income for Mather Group, a financial advisory firm in Chicago.
On the shorter side, ETFs can also be used for cash management beyond the limited scope of money-market funds. In the wake of new Securities and Exchange Commission rules that constrained money-market-fund holdings, “ultrashort" bond ETFs such as the $26 billion SPDR Bloomberg 1-3 Month T-Bill ETF (BIL) have seen a wave of interest this year. BIL alone has experienced $12.9 billion in net inflows as the yield has climbed to 2.6%.
Focused credit
Other ETF innovations have focused on more-targeted credit risk, such as specific levels of credit quality or high-yield sectors. Trying to predict gains in specialized debt sectors, however, can be challenging. (Who could have predicted that energy would outperform?)
“Investing outside of the U.S. fixed-income markets is [also] a great way to extend the diversification of a bond allocation beyond the U.S. economy, its single yield curve and single central bank [the Fed]," says Vanguard’s Mr. Croke.
Don’t overdo it
Mr. Croke warns, however, that straying too far from the “ballast-ness" of sturdy fixed-income investments can reduce the diversifying and stabilizing effect that fixed income has on a multiasset portfolio.
“A bond allocation that ‘diversifies’ beyond high-quality bond sectors into high-yield and other lower-quality sectors may in fact diversify your bond allocation on paper," says Mr. Croke. “However, it will also reduce its diversifying effects on your equity allocation, resulting in an overall portfolio that’s riskier than what you began with."
Excencial’s Mr. Courtney reminds investors why they invest in bonds. “It’s first about liquidity and second about return above inflation," he says. For liquidity, bond funds and ETFs offer more liquidity than most bonds beyond U.S. Treasurys. As for covering inflation risk, bonds lagged behind inflation in roughly 33% of annualized periods (one to 20 years) going back to 1926 across short-term to long-term Treasurys as well as long-term corporate debt.
Mr. Croke suggests checking allocations at least once a year “to determine if your circumstances have changed, tolerance for risk has evolved, or if the objective and time frame for a given pool of assets needs to be modified."
