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The domestic bond market in the U.S. has witnessed material shifts in the recent past. Perceived as one of the ‘safest’ investment avenues in the world, the U.S. Dollar denominated Treasury Bonds have a long tradition of being the ultimate savior for the investors seeking refuge from the turmoil in the global economy.

To start with, let us consider the past five years. The gloomy days of the 2008 sub-prime crisis are still fresh in the memories of investors worldwide. Not only did it threaten to doom the entire U.S. financial system, but also caused massive losses across major stock exchanges across the globe. (read 3 Safe Havens to Weather the Storm

In October 2008, when Lehman Brothers filed a bankruptcy petition (which marked the beginning of the crisis), the benchmark 10 year Treasury rates were hovering near 3.82% levels around. As a result of global risk aversion and widespread fear among investors, the yields dropped sharply to end the year at around 2.25% level.

Similarly, the 20 year Treasury rates plummeted to 3.05% from 4.50% and the 30 year Treasury rates to 2.69% from 4.21% as of those dates. Of course the rates rebounded on account of fresh stimulus from monetary authorities to tackle the ongoing crisis and restore growth. (read How Low Can Yields Go?)

Looking at the present scenario--the U.S Treasury Bonds (especially the long dated ones) have witnessed a significant rally in the past one year, mainly thanks to the Eurozone debt crisis and economic slowdown in most parts of the world. Due to a sharp increase in volatility in the equity markets across the board the investors shifted to a ‘flight to safety’ mode. (see Three Low Volatility ETFs For Stormy Markets)

The sovereign rating of the U.S. was downgraded to ‘AA+’ by rating agency Standard and Poor’s back in August last fiscal. Technically it was supposed to push interest rates upwards due to the added default risk premium; however, rates continued to plunge on account of the worsening debt situation across the Atlantic, making the U.S. Treasury bonds the ultimate safe haven.

As a result, income seeking bond investors are forced to look at other investment options for their current income needs, during times of low yields.

Thankfully, there are a variety of choices available to investors in the exchange traded funds category. Preferred stocks ETFs can make for a great source of current income. PFF currently yields 5.80% and is up by 10.86% on year-to-date basis. Also, PGF has a solid annual distribution yield of 6.62% and has returned 13.40% so far this year. (read Complete Guide to Preferred Stock ETF Investing)

However, preferred stock ETFs are not very popular investment vehicles, mainly thanks to the highly complex and hybrid nature of these instruments. Moreover, the issuers of preferred stocks are mostly from the banking industry, who issue these securities to strengthen their Tier I capital. Many investors are still hesitant to invest in the banking industry, given the current volatile state of the economy.

We would like to highlight seven products from the ETF industry, targeting the bond space. These presently yield more than the benchmark 10 year Treasury rates of 1.83%. These ETFs provide investors with a basket of securities from various issuers across different maturity buckets.

However, these seven ETFs vary across different genres, weighted average duration and residual maturities. Therefore each of these products demands a different risk appetite and time horizon. Below is a table which summarizes the types, performances and interest rate sensitivity of each of these products, followed by a brief discussion about each of these ETFs. 

 

ETF

Type

1 Year Returns (as on 30th June)

Year Till Date Returns (as on 30th June)

Average Duration

Average Maturity

Yield

ELD

Emerging Market Bond

-2.28%

4.66%

4.4 yrs

5.14 yrs

3.61%

BND

Total Bond Market

6.87%

2.60%

5.1 yrs

7.1 yrs

2.93%

BIV

Total Market (Intermediate Term)

9.64%

3.92%

6.4 yrs

7.3 yrs

3.57%

EMB

Emerging Market Bond

9.74%

7.60%

7.59 yrs

12.08 yrs

4.45%

LQD

Corporate Bond

11.40%

5.14%

7.78 yrs

12.06 yrs

3.89%

VCLT

Corporate Bond

19.89%

5.72%

13.9 yrs

24.4 yrs

4.28%

EDV

Government Treasury

64.45%

8.06%

26.3 yrs

24.7 yrs

2.65%

In the past one year we have seen a considerable fall in yields, not only across Treasury bonds but also across corporate bonds. Therefore not surprisingly, as we climb up the yield curve, the returns tend to improve (as can be seen from the table above). For example, BND which has an average duration of 5.1 years and an average maturity of 7.1 years has returned 6.78% in the past one year. However, during the same time period, EDV has returned 64.45% with average duration of 26.3 years and average maturity of 24.7 years.

Fixed income securities at the longer end of the yield curve (having a higher duration) tend to outperform their shorter end peers in a falling interest rates scenario since they are more sensitive to interest rates.

For investors seeking true emerging market exposure in the fixed income security space, the WisdomTree Emerging Markets Local Debt ETF (ELD - ETF report) is truly the appropriate option. The ETF tracks the performance of domestic debt securities denominated in local currencies from a variety of emerging markets. Though emerging markets have a higher economic growth rate than developed markets, investing in emerging market debt securities would mean taking an additional amount of risk in the form of default risk premium. This is also because most emerging markets sovereign debt ratings are inferior to those of developed nations. (read Emerging Markets Sovereign Bond ETFs: Safe With Attractive Yields)

Of course, investors are compensated for this in the form of higher yields. Also, investments in ELD would constitute of high levels of currency risk, as the assets of the ETF are denominated in a variety of currencies.

Nevertheless, with a distribution yield of 3.61%, ELD ensures high levels of current income and diversification in terms of country exposure. Brazil, Chile, Columbia, Mexico, Peru and Poland are some of the countries which the ETF is exposed to.

ELD was launched in August of 2010 and has managed to amass $1.20 billion in total assets. It charges investors 55 basis points in fees and expenses and has an average daily volume of 221,947 shares.

Also targeting the emerging market bond space is the iShares J.P. Morgan USD Emerging Markets Bond (EMB - ETF report). It tracks the performance of the U.S. Dollar denominated emerging market bonds as defined by the J.P. Morgan EMBI Global Core Index. The index limits exposure to countries which have higher debt and allocates more to countries with lower debt levels. (see Japanese Bond ETF Investing 101)

It also takes into account various other factors pertaining to liquidity and issuing bodies in order to include securities in its portfolio. EMB allocates almost evenly across a variety of emerging markets, some of which include Brazil (7.62%), Mexico (7.32%), Russia (7.24%), Turkey (7.06%) and Philippines (6.95%).

The ETF charges 60 basis points in fees and expenses and has total assets of $5.20 billion. However, while comparing it to its counterpart ELD, it has certain added advantages like1) absence of currency risk which may somewhat limit returns potential, 2) a superior distribution yield of 4.45%. EMB was launched in December of 2007 and has an average daily volume of 664,865 shares.

Now  let us look at the total bond market ETFs. The Vanguard Total Bond Market ETF (BND - ETF report) and the Vanguard Intermediate-Term Bond ETF (BIV - ETF report) are two offerings by Vanguard in the total bond market space. Total bond market ETFs provide hybrid exposure across the entire bond market and measure the performance of investment grade debt securities which are issued by corporates, government and other institutions.

BIV targets the intermediate end of the yield curve and holds securities of residual maturities between 5 to 10 years. It tracks the Barclays Capital U.S. 5-10 Year Government/Credit Bond Index and the portfolio comprises of 52.7% of U.S Government Bonds. BIV also adds an international flavor to its portfolio as around 47.3% of the portfolio is comprised of securities issued by other international bond market participants.

On the other hand BND tracks the pre expense price and yield performance of the Barclays Capital U.S. Aggregate Bond Index. The index measures the performance of only those investment grade securities which are traded in the U.S domestic bond market. A major portion of its portfolio is allocated towards the U.S treasuries (69.7%).

The difference in allocations towards the U.S. Treasuries between BIV and BND explains the difference in yields. Since U.S. Treasuries are generally low yielding, the fund that allocates more towards them i.e. BND has a lower yield of 2.93%, whereas BIV which allocated less than BND to the U.S sovereign bonds have a superior yield of 3.57%. (see Three Impressive Small Cap Dividend ETFs)

Both the ETFs charge expense ratios which are lower than the category average of 0.23%. BND charges 10 basis points whereas BIV charges 0.11% in fees and expenses. From a holdings perspective, both the ETFs hold a relatively large number of securities in their portfolio. BND holds 5230 securities whereas the portfolio for BIV consists of around 1338 investment grade securities.

Both these total bond market ETFs share a similar position in the yield curve. Although both ETFs were launched around the same time on April 2007, in terms of popularity and liquidity BND clearly is the leader. BND’s total assets are $17.36 billion compared to BIV with $3.15 billion in total assets. BND has an average daily volume of 1.18 million shares whereas roughly 262,541 shares of its cousin exchange hands each day.

Like Treasury bonds, US corporate bonds’ prices also remained largely unaffected by the  sovereign credit rating  action. (see Top Four High Yield Bond ETFs) Nevertheless this failed to cause any material impact in the corporate bond market in the U.S. That was because the limelight had already been stolen by the ongoing debt crisis in its cross Atlantic counterparts.

The iShares iBoxx $ Invest Grade Corporate Bond (LQD - ETF report) and the Vanguard Long-Term Corporate Bond ETF (VCLT - ETF report) are two products from the plain vanilla corporate bond ETF space.
 

Launched in September of 2002, LQD is by far one of the most popular, highly diversified and best performing corporate bond ETFs available to investors. Its total assets stand at a whooping $23.46 billion and it has an average daily volume of about 1.98 million shares. It tracks the iBoxx $ Liquid Investment Grade Index which measures the performance of the investment grade corporate bonds in U.S markets.

iBoxx $ Invest Grade Corporate Bond ETF (LQD - ETF report)has an extremely well diversified portfolio of 978 securities issued by some of the biggest names in Corporate America and therefore of high credit quality. Some of its exposure includes Wells Fargo & Co (0.49%), AT&T Inc. (0.49%), Wal-Mart Stores Inc (0.48%) General Electric (0.47%) and American International Group (0.46%). The ETF is highly exposed to issuers from the financial sector (35.25%) (read Can You Beat These High Dividend ETFs?).

Around 70% of its portfolio is allocated towards securities having a residual maturity of less than, or equal to 10 years. It has an annual distribution yield of 3.89% and has returned 11.40% in the last one year period as on 30th June 2012. (See table above). It charges investors a paltry expense ratio of 0.15% compared to a category average of 18 basis points.

On the other hand VCLT targets the longer end of the yield curve and measures the performance of corporate bonds issued by various issuers having a residual maturity of more than 10 years as measured by the Barclays Capital U.S. Long Corporate Index.

The ETF was launched in November of 2009 and has been able to attract an asset base of $958.83 million. It charges investors 14 basis points in fees and expenses and pays out an impressive yield of 4.28% (see 3 Multi-Asset ETFs for Juicy Yields and Stability) However, it has a superior interest rate risk as indicated by an average duration of 13.9 years.

VCLT holds 1109 securities in all, issued by corporates across various sectors. Industrials (63.8%), Finance (17.8%) and Utilities (17.4%) are some of the sectors on which it lays maximum emphasis. Almost 78.3% of its assets are allocated towards securities having a residual maturity of 20 to 30 years.

Finally, we talk about the Vanguard Extended Duration Treasury ETF (EDV - ETF report) which tracks the Barclays Capital U.S. Treasury STRIPS 20-30 Year Equal Par Bond Index. The index measures the returns of U.S. Treasury securities which are highly sensitive to interest rate changes and of residual maturities ranging from 20 to 30 years.

A STRIPS play on the treasury bonds means that the interest payments and principal repayments are made independent of each other and are treated as separate components (see Convertible Bond ETFs for Income With Growth Potential). While this may seem an enticing option for investors providing separate plays on the two payment obligations of a debt security, it is worthwhile noting that this is an extremely complex investment strategy.

However, the ETF has had a fantastic run in the past one year returning 64.45% in the past one year as on 30th June 2012. EDV targets the longest maturity bucket in the treasury yield curve, and has a distribution yield (2.65%) far more superior than most ETFs targeting the zero-coupon and money market bonds. (see Comprehensive Guide to Money Market ETFs)

Also, adding to the flavor is the low expense ratio of 13 basis points which is 0.02% lower than the category average. The ETF holds only 54 securities in its portfolio. The ETF was launched in December of 2007 and has an asset base of $208.93 million. However, investing in EDV requires a steady appetite for risk as an average duration of 26.3 years indicates that the interest rate risk is quite high for this product.

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