If you're a long-term investor, equities are where most of your money should usually be. However, a fixed-income ETF that tracks a bond index can diversify your portfolio and provide monthly income. Compared to purchasing one or two corporate bonds, which is all the diversification many individuals can afford, a fixed-income ETF is a lot less risky. The expense ratios are also much lower than those associated with a typical bond mutual fund. In addition, a fixed-income ETF can be purchased for a low minimum investment with just one trade.
If you want an index-based fixed-income ETF, the only choices right now are the iShares, issued by Barclays Global Investors (BGI). There are six funds available which provide broad or targeted exposure to U.S. Treasury and corporate bonds. Three of the funds focus on a specific range of treasuries: iShares Lehman 1-3 Year Treasury (AMEX: SHY ) ; iShares Lehman 7-10 Year Treasury (AMEX: IEF ) ; and iShares Lehman 20+ Year Treasury (AMEX: TLT ) . All three of these funds have a very low .15% expense ratio. The respective returns so far this year are 3.1%, 2.2%, and .48%. If you're worried about inflation, you can invest in the iShares Lehman TIPS Bond (NYSE: TIP ) , which invests in treasuries that are inflation-protected. This fund has a .2% expense ratio and a year-to-date return of 1.6%.
You have two other fixed-income ETF options. One is the iShares GS $ InvesTop Corp Bond (AMEX: LQD ) , which tracks the corporate bond market as defined by the Goldman Sachs $ InvesTop (TM) Index. Holdings at the end of September were 48% financials; 20.5% consumer; 13.7% industrials; and 12.9% telecom and technology. The fund's return so far this year is 3%, with a .15% expense ratio. The iShares Lehman Aggregate Bond (AMEX: AGG ) , focuses on the U.S. investment-grade bond market as defined by the Lehman Brothers U.S. Aggregate Index. Portfolio holdings at the end of September 2006 were 24.5% U.S. Treasuries; 17.5% FNMA; 13.9% financial institutions; 13.4% FHLMC; and 11.2% U.S. agencies. Returns so far are 2.8%, while the expense ratio is .2%.
Fixed-income ETFs still share some of the same market-moving characteristics of individual bonds. The primary factor to watch out for is interest rates. Rising rates will cause both the ETF and bond prices to fall and vice versa. Typically, the longer a bond's duration, the greater the price movement. This equation also holds for the ETFs.
Fixed-income ETF benefits
Fixed-income ETFs provide diversification with one trade, transparency of pricing throughout the day on an exchange, and low costs, and they require only a minimum investment.
ETFs trade on stock exchanges, whereas bonds are generally bought and sold through dealers. Trading on a stock exchange means that investors can execute trades just as they would with any listed stock. Also, price quotes and trading history for ETFs are available in the same manner as for listed stocks. Bonds, on the other hand, are often traded in the dealer market, where price and quantity are not usually observable.
Low fees are especially important to fixed-income investors, since the expected returns are much lower than in stocks. High expenses are to be avoided, since they can reduce those low returns.
Fixed-income ETFs usually distribute monthly dividends, which can include both interest income on the underlying bonds and capital gains. Most individual bonds pay interest semiannually, so the income stream from the ETFs may be more suited to meeting monthly obligations like mortgages or car payments.
Unlike bonds, ETFs don't have a maturity date. When bonds mature in an ETF, the money from the payoff is reinvested in new bonds rather than the principal being returned to investors. Finally, because ETFs can be purchased on margin and sold short, fixed-income ETFs can provide a vehicle for investors to hedge interest-rate fluctuations. Of course, that's assuming you can forecast the trend in interest rates.
The iShare ETFs blend maturities to reach a favorable yield, but unlike with bond purchases, this does not lock in that favorable yield. Treasuries can go down in value, and at maturity you get your par value back. This is not the case with a Treasury fund, for which there is no guarantee that you will get back the principal you invested. The deletion of maturing bonds from bond indexes and the addition of newly issued bonds may result in higher turnover rates for ETFs than for equity funds.
For individual investors, it isn't difficult to purchase a Treasury, since there's usually no commission and they can be bought in relatively small amounts. A traditional mutual fund like the Vanguard Long-Term U.S. Treasury (VUSTX) has an expense ratio of .26% and a year-to-date return of 1.4%; the T. Rowe Price Short-Term Bond fund (PRWBX) has an expense ratio of .55% and total return so far this year of 3.3%. You can also make trades in many traditional mutual funds for free, while the ETF will cost you a commission on every buy and sell.
More funds to come
There are many options to choose from when looking at equity ETFs, but fixed-income investors don't have many choices. This limited selection is about to improve, as Ameristock Funds has plans to launch five fixed-income ETF funds based on the Ryan indexes. These ETFs will provide investors exposure to a single time horizon, in contrast to the BGI funds, which follow indexes that cover a blended time horizon. The Ameristock ETFs will follow indexes for one-, two-, five-, 10- and 20- year Treasuries and can be used for obligations like college expenses that occur at a specific time in the future. The Ameristock funds will have the same .15% expense ratio as the cheapest BGI funds. For those not familiar with Ameristock, they also run the U.S. OIL FUND ETF (AMEX: USO ) .
Fixed-income ETFs used in a portfolio
If you have assets in a money market account and feel comfortable assuming a bit more risk, you can move some money into the shorter-duration fixed-income ETFs. This will give you a little higher return, of course with a slightly increased risk.
For broad exposure to fixed income, you can create a laddered portfolio using ETF treasury funds with varying maturities. Or if you want to be a little more aggressive, the corporate fixed-income ETFs can be used. If you are even more aggressive than that, your fixed-income ETFs can be sold short to hedge interest-rate fluctuations.
Fixed-income ETFs may not be the sector or hot fund of the day, but they can provide diversification and income. At some point, these characteristics will be of more interest, maybe when equities take their periodic fall off the cliff. Bonds may be boring, but they are worth considering for at least a portion of your portfolio.
For more on ETFs, be sure to visit our ETF center.
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Fool contributor Zoe Van Schyndel lives in Miami and enjoys the sunshine and variety of the Magic City. She does not own any of the funds mentioned in this article. The Motley Fool has a disclosure policy.