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Fixed-Income Fever

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.

Today's menu
With its recent fixed-income ETFs, BGI now offers fixed-income funds clustered in the Treasury, corporate, and mixed security markets and one asset-backed fund. There are seven iShares funds that cover the spectrum of U.S. Treasury securities. Investors looking for a little higher yield have one investment-grade corporate bond fund to choose from. Then there are three credit bond funds and two government/credit fund options. Those investors who want to mix it all together have one aggregate bond fund to select from. Finally, a mortgage-backed securities fund is the latest addition to BGI's lineup, and a high-yield fund is in the registration queue at the SEC.

General risk considerations
Although bond funds are usually considered to be more conservative investments than stock funds, they do have risks. Interest rate changes are usually the most common risk that bond funds face. When interest rates rise, bond fund prices will fall, and when rates fall, bond fund prices will rise.

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
Current treasury funds range from the very short-term iShares Lehman Short Treasury Bond Fund (NYSE: SHV  ) , to a 20-year-plus fund. In between are funds that offer investors the ability to incrementally increase their treasury exposure by three years at a whack up to the 10-year point. There's one fund that covers the 10- to 20-year treasuries, and another for treasuries beyond 20-plus years.

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
Investors looking for a fund that invests in the most liquid, investment-grade corporate bonds have an easy decision to make since there's only one ETF to choose from -- the iShares iBoxx $ InvesTop Investment Grade Corporate Bond Fund (AMEX: LQD  ) . If you aren't so concerned about liquidity, there are three credit bond funds that invest in the investment-grade credit sector in three different slices: one to three¬†years, one to 10 years, and anything greater than a one-year maturity.

Mixed options
Two of BGI's new funds are mixed government/credit funds options, which invest in U.S. government and investment-grade corporate securities. A more established standby is the iShares Lehman Aggregate bond Fund (AMEX: AGG  ) . This fund plays in the total U.S. inve