Fixed-Income Feverhttp://www.fool.com/investing/etf/2007/04/04/fixed-income-fever.aspx Zoe Van Schyndel, CFA
April 4, 2007
Amazingly enough, BGI's iShares have been the only choice for fixed-income ETFs for many years. With a miserly half dozen funds, the fixed-income universe for ETF investors was limited to shades of gray rather than a full palette of options. In early 2007, BGI expanded the number of funds it offers to a total of 15 and more than doubled the existing fixed-income ETF universe.
Competitors are catching the fever and are champing at the bit to add more funds. There are already enough fixed-income funds in the works to soon bring the total offerings to two dozen. The analysis necessary to find an appropriate fund has expanded with the number of choices.
General risk considerations
With an investment in a fixed-income ETF, there are two components to your return: income from coupon payments, and capital gains from a change in the value of your principal. If coupon payments are fixed, that component of your return will not change over the life of the bond. Principal values, on the other hand, can change with fluctuations in interest rates or in the event of credit risk changes (for example, a downgrade or default).
As the yield of the fund goes up, it's usually safe to assume that the risk is going up as well. The hierarchy of risk can be generalized to start fairly low with treasury securities and then move up with corporate bonds.
U.S. Treasury ETFs
Sometimes there's a misplaced belief that U.S. Treasury bonds are completely safe. While it's true that these securities, and the ETFs that invest in them, have the government's guarantee of timely interest and principal payments, there's no guarantee against losses that result from rising interest rates. If interest rates rise, bond and ETF prices will fall. Short-term bond funds don't lose as much value in a rising interest rate environment. This means that when you pick a 20-year U.S. Treasury ETF, it will have more interest rate risk than a short-term treasury. Of course, that risk works for you when rates fall, as the treasury bonds and ETF prices will rise.
For those investors worried about inflation, BGI offers a treasury fund that invests in inflation-protected securities, the iShares Lehman TIPS Fund (NYSE: TIP ) . The underlying U.S. Treasury bonds in the fund adjust their coupon payments and underlying principal automatically to compensate for inflation as measured by the consumer price index. That means investors in the fund can have a reasonable measure of comfort that inflation will not eat away returns.
Corporate bond ETFs