Bonds (Part 4)

As commenters to my previous posts have pointed out, today a much easier way to participate in the bond market is via exchange traded funds (ETFs).  When you do an asset allocation and determine that a certain percentage of your assets, 30% say, should be allocated to bonds or fixed income, think exchange traded funds.  You immediately get diversification and avoid the pricing problem with odd lots of individual bonds.  You have available at your fingertips mounds of research data detailing portfolio composition, yield, duration, etc.

A natural choice, right off the bat, would be a fund indexed to the Barclay's Aggregate Bond Index.  This index is to the bond market what the S&P 500 is to the stock market.  It is the #1 benchmark active managers try to beat   (most are unsuccessful by the way).

A really good source of bond ETF data is Morningstar.  Put the ETF symbol in the quote box, and then putter around and check out the data under the various tabs.  For example, for AGG, you'll find under the" Portfolio" tab on the right hand side, after scrolling down, the fund duration is 4.50 years.  This is the number of years it takes to receive the presented weighted cash flows of the bonds in the portfolio. Duration is also the approximate change in the price of the fund's bonds for a 100 basis point (1%) move in yields.  If the yield on the 10-year Treasury note, for example, rises from approximately 2% now to 3% 12 months from now, then AGG could be expected to drop in price by roughly 4.5%.  Because the yield on AGG is approximately 3.2%, the total 12-month return would be around 1.3%.

You should be able to do the math and figure out the impact of a sharp rise of 2 -3% in rates.  For comparison purposes, the  ETF with symbol TLT indexes the longer maturity portion (20+ years) of the Treasury market and has a duration of 15.4 years.  For a period where yields change a lot,  this ETF will either hit the ball in the upper deck or strike out big time!

There are, of course, all kinds of bond ETFs available.  Most of my clients are with Schwab, and I rebalance frequently so I use Schwab's commission-free funds (SCHZ is Schwab's counterpart to AGG) which also have low expense ratios.  Some ETFs are devoted entirely to corporates; some index the international market.  There are low duration and high duration funds.  There are ETFs indexed to the mortgage-backed market.  All of these can be used to tailor the fixed income portion of a portfolio to fit a given interest rate outlook.  Here is a good source of bond ETFs:  Bond ETF List.

There are also many leveraged bond ETFs that can be used to magnify the impact of  increases and decreases in yields.  I would stay away from these unless you view yourself as a highly-seasoned trader and are positioned to take on the risk of these instruments.

Disclosure:  The information here is solely for educational purposes.  Individuals should do their own research or consult a professional advisor before making investment decisions.  I own some of the ETFs mentioned  here.