Should I diversify the types of Bond ETFs I want to buy?
When buying bond ETFs, should I diversify the types of bonds, or can I buy three of strong performing corporate bond ETFs, such as the ones recommended in your article?
I'll make the assumption that you would like to keep things simple with your investing because you are interested in ETFs. There is good news. If you want to build out a diversified bond portfolio, you can do so with a small cohort of ETFs. There are several that track the Bloomberg/Barclays Aggregate Bond Index. This benchmark subsumes about 80% of the US public debt market. It's pretty comprehensive. The major bond asset classes that are omitted are treasury inflation-Linked securities (TIPs), junk bonds, and municipal bonds. These too are represented by low cost ETFs.
You could build a bond portfolio in a tax sheltered account that need not include tax-free municipal bonds. Use AGG or BND to capture the broad investment grade market represented by the aggregate bond index. Both have management fees under 0.10%. Use TIP to include Treasury Inflation-Protected securities and HYG to invest in junk bonds. Passive bond portfolios are an excellent option in the fixed income markets. Morningstar issues an Active/passive Barometer twice a year to compare the performance of active managers against passive managers. The ten year results ended December 31st, 2015 and revealed that only 39.7% active bond managers outperformed their indexed counterpart funds.
There is bad news even for those managers that do beat their benchmark. Vanguard's latest Persistence Scorecard reveals that top quartile bond managers are no more likely to remain in that position than random chance would allow. In other words, there is no consistency in the quality of active bond management. You are well served to use a few ETFs to build out a bond portfolio.
You should always attempt to diversify somewhat. If your question is 3 strong performing corporate bond ETFs within the same sector i.e. investment grade bonds, then I would look at the top 10 holdings in each ETF to see how much overlap there is. You might be surprised. Another thing you can do is to compare the correlation between the ETFs. This can be done easily on a chart. But if they are very correlated, you may not be getting the diversification you think you are by owning 3. Thus, they may have all done well at the same time, but will also do poorly at the same time and go down together.
A more important factor is the direction of interest rates. If you believe interest rates are on the rise, then you need to shorten your maturity and duration (not quite the same thing). I personally am not going to own any L-T bonds at the moment unless it is for a shorter term trade rather than an investment. I would focus on investment grade mid-term bonds (5-7 years) and wouldn't go out much further. This is because I believe the long term dropping interest rate cycle is over, and thus, the long term bull market in bonds may be coming to an end. In fact, depending upon the sector and more importantly duration, bonds have lost anywhere from 3% to 7% in value since peaking last year in the early fall.
And if interest rates do rise, it will hurt the real estate market. So, I think you are in the right sector, but need to make sure you are also picking the right maturity. Don't get lured into the higher interest of longer term bonds because they will also have higher losses if rates rise.
Now the opposite would be true when rates are dropping. When rates are likely to drop, that is when you would want longer term bonds for the higher interest and higher capital gains. This is my personal opinion and I just feel that the bond market carries more risk than it did just a year ago. So, the very first question you must ask yourself is which direction do you think rates are headed? Then, what effect will it have on the various sectors?
I hope this gives you some perspective for your research. Best of Luck, Dan Stewart CFA®
Bond ETFs range widely between different fixed income asset classes. There is a variety of bond ETFs that focus on short-term, intermediate, long-term treasuries, corporate bonds, high yield, TIPs, floating rate bonds, international, preferreds, municipal bonds, as well as a growing number of smart beta ETFs.
How to invest the fixed-income portion of your portfolio depends a lot on your risk tolerance, target allocation, and long-term financial goals. I generally recommend diversifying in multiple fixed income asset classes to lower the risk of your portfolio. Some of assets, like corporate bonds, have a very strong correlation to the equity market, and others like treasuries have a negative correlation.
Hope that helps.
I highly recommend diversifying the bonds you invest in, whether it be through a mutual fund or ETF. Now, if the ETF is already spreading the bond exposure to various bond investment classes, you have already achieved some diversification. However, many bond ETFs track a specific type of bond category like investment grade, high yield, or government, etc. Those are all very different in terms of their risk and return characteristics.
How you diversify depends a lot on your investment objective, risk tolerance, and time horizon. So there isn’t one “right” way to do this. I wrote in more detail about this in my article Bond Fund Basics – What You Need To Know. While the article focuses on mutual funds, it is applicable to ETFs as well. I hope you find it helpful. What you must understand before investing in bond funds or ETFs is the concept of duration and credit quality. As always, be sure to consider the track record, rating, and cost before you invest.
Please note that this should not be considered investment advice and is only educational in nature. Be sure to consult your own investment, tax, or legal professional for help with your specific situation.
Best of luck!
David N. Waldrop, CFP®
I would definitely diversify the type of bond ETFs you buy, there is no need to buy 3 different ETFs that track the same index, their return and risk will be very correlated. Depending on current and future expected market conditions, you'll want to consider corporate high yield bonds, corporate investment grade bonds, TIPS, mortgage backed bonds, government bonds, and international corporate/government bonds, all in short, mid, and long term maturities.
I wouldn't buy a bond ETF for each of these asset classes, but do some research and pick the classes that suit your risk tolerance and opinion on which will perform the best over the long term.