Fixed Income ETFs

Fixed income plays a crucial role in most investors’ portfolios, because the asset class can offer a way to achieve diversification. Fixed income as an asset class comprises a variety of different types of securities; bonds are the most commonly known kind. In the marketplace, “fixed income” and bonds are usually used interchangeably to refer to the same thing. Other examples of fixed income instruments include mortgage-backed securities, asset-backed securities and convertible debt.

How Fixed Income ETFs are constructed

Some fixed income ETFs seek to track an index or underlying investment product. However, many fixed income securities in various indexes are not liquid, meaning they do not trade on a regular basis. As a result, the full replication of a traditional fixed income index, such as the Bloomberg Barclays U.S. Aggregate Bond Index (which holds over 6,000 securities), is nearly impossible. That being the case, ETF managers attempt to reflect the risk and return characteristics of popular fixed income indexes by sampling a basket of liquid securities that trade frequently and closely track the index.

Once a portfolio of fixed income securities is created, the sampled portfolio is optimized and tested to see whether there is a significant difference in the past risk and return of the portfolio and that of the index the portfolio is trying to track. If the tracking error relative to the index is too high, securities are replaced in the portfolio. This procedure continues until the portfolio’s tracking error is within an acceptable tolerance. A successful sampling and optimization strategy should require only a few hundred fixed income securities to bring the tracking error within an acceptable level.

Types of ETFs

The ETF fixed income market is composed of many types of securities. They include, but are not limited to, government bonds, mortgage-backed bonds, provincial and municipal bonds, corporate bonds, high-yield bonds, international bonds, convertible bonds, inflation-protected bonds, short-term bonds, intermediate-term bonds, long-term bonds, leveraged bonds and inverse bonds. Some ETFs hold only one type of fixed income security, and others hold a combination of these different types of fixed income securities.

Fixed income indexes divide maturities into three ranges. Short-term indexes hold fixed income securities that have an average maturity of three years or less, intermediate-term indexes hold fixed income securities with an average maturity of four to nine years, and long-term indexes hold fixed income securities that have an average maturity of ten years or longer. If an index has an average maturity of five years, that does not mean all the securities in the fund will mature in five years. Bonds could have maturation dates from one year through ten years, or any combination thereof. Read the prospectus of the ETF you are interested in so you understand how the index is designed.

Interest rate and credit risk

Fixed income index average duration is an important characteristic that investors should monitor. Duration is a measure of interest rate risk. If interest rates move higher, ETFs benchmarked to indexes with longer durations will decrease more in value than ETFs benchmarked to indexes that have shorter durations. In the long term, since there is more risk in long-duration fixed income securities, you should expect indexes with long durations to generate a higher total return than indexes with a short duration.

Credit risk is a reflection of the financial strength of the issuer. The higher the credit risk, the greater the chance of a default, and the higher the interest rate needs to be to compensate for that risk. The credit risk of government and government agencies is low. Corporate bonds that are investment grade are higher in risk (relative to government issues), and at the top of the risk level are high-yield bonds. Funds invested in below-investment-grade debt are the riskiest because they have a higher probability of running into trouble.

The important point is this: as the duration of an index increases and as credit quality decreases, the potential for long-term return of a fixed income index increases to compensate for those extra risks.

Choosing the right fixed Income ETF for you

As with any type of investment, fixed income ETFs have defined risk and reward characteristics. You should determine your own risk-reward profile for the ETF portion of your portfolio and then choose fixed income ETFs that correspond to that profile. For example, if your goal is to minimize risk in your portfolio, consider short-duration government ETFs. If you’re willing to take on maximum risk (within the fixed income ETF market) in exchange for a higher return to achieve a certain investment goal, you may want to consider a high-yield corporate bond ETF.

Probably because fixed income instruments are generally not as volatile as stocks, most investors pay less attention to the fixed income side of their portfolio. But with ETFs now available for every duration and sector in the fixed income market, as well leveraged and inverse products, investors need to make an effort to understand the variety of fixed income ETF products and how they perform in different interest rate and economic environments.