Strong Bond ETFs In A Bond-Eroding Economy

By Aaron Levitt | August 29, 2012 AAA
Strong Bond ETFs In A Bond-Eroding Economy

Since the depths of the financial crisis, it hasn't been easy going for income seekers. Sure, bond prices have surged as investors have continued to flock to safety, and that certainly results in some nice capital appreciation, but no good deed goes unpunished. Those rising bond prices have pushed dividend yields on products like the Vanguard Short-Term Bond ETF down lower and lower. At the same time, the Federal Reserve, in order to stimulate growth, has kept interest rates at historically low levels. That's caused other traditional income products, like CDs and money market accounts, to pay roughly zero.

Add these low yields to rising inflation expectations and the current investing environment isn't so friendly for bonds. With millions of Baby Boomers about to enter their golden years, finding good sources of high income has become a paramount issue. Luckily, the exchange traded fund boom has given investors access to a variety of bond types that should do well in the current unfriendly bond environment.

SEE: Bond ETFs

Low Yields, High Inflation
According to J.P. Morgan's CIO Gary Madich, the current rate environment is "beyond challenging" for bond investors. First, with interest rates at historically low levels, most traditional sources of income such as cash, CDs and short-term bond funds are paying next to nothing. When adding in current and future inflation expectations, many of these asset classes are actually losing purchasing power. That has caused many investors to expand outwards to bonds with longer maturities; however, that's no bargain either.

With long-term inflation expectations high, eventually the Fed will have to raise rates. Ultimately, that will cause a portfolio of fixed-income securities to lose value. Bonds with longer maturities suffer more than those that are shorter. The longer the maturity of the bond, the bigger the swing in prices. Again, with short-term bonds paying next to nothing, investors looking to fund their liabilities today are facing a quandary.

Luckily, the proliferation of ETFs has created some ways to help navigate the current bond environment. Here are some ideas for a few strong portfolio contenders.

SEE: Active Vs. Passive ETF Investing

Betting on Bank Loans
With rates that adjust every 30 to 90 days, senior-rate bank loans make an attractive portfolio option in the current environment. Senior loans are generally issued to companies with less than stellar credit ratings and are often secured by a company's physical assets, such as a pipeline, warehouses or equipment. That fact allows them to offer higher starting yields than treasuries, but the adjusted rate feature allows them to perform well in rising rate environments.

The PowerShares Senior Loan Portfolio is the largest ETF in the sector. The fund tracks 117 different floating rate loans from a variety of issuers and the average coupon duration/reset is just 32 days. That means the ETF's impressive 5.1% distribution yield will only grow when the Fed raises rates. Expenses run a relatively cheap 0.76%. Likewise, the new iShares Floating Rate Note makes an ideal portfolio candidate as well.

Big Yields in Hybrid Bonds
While preferred stock has been widely adopted by the general investing public, their bond/equity twins, convertible bonds, have been largely ignored by retail portfolios. At their core, convertibles are basically a bond with a stock option hidden inside. Much like traditional bread-and-butter bonds, converts have face values, coupon payments and maturity dates, but can be exchanged for a specific number of shares of the issuer's common stock at a later date.

That allows investors to collect a treasury beating yield today, while participating in any upside in the stock market. Typically in high inflation environments, investors will seek higher returns and rush into equities to get ahead. With nearly $779 million in assets, the SPDR Barclays Capital Convertible Securities is the largest ETF in the sector. The fund tracks 101 different converts from issuers such as Intel and Chesapeake Energy and yields a healthy 3.29%. The ETF has performed well, producing an annualized 12.47% return since its inception in 2009.

SEE: Convertible Bonds: Pros And Cons For Companies And Investors

Look Across the Pond
Finally, one of the better solutions to realizing current high yields, as well as protecting for tomorrow, can be found by looking across the sea to other nations. As the dollar is expected to resume its multi-year decline, getting paid in a variety of other stronger currencies will help lessen interest rate risk. Likewise, many foreign issued bonds offer higher current yields than similar U.S. sponsored debt. Both the Market Vectors Emerging Markets Local Currency Bond and the actively managed WisdomTree Emerging Markets Local Debt provide investors with generous 4 to 6% dividend yields and make a good choice in the international bond space.

The Bottom Line
With interest rates low and inflation expectations high, investors seeking income are faced with a huge problem. Traditional income sources just aren't cutting the mustard for portfolios. Luckily, the exchange traded fund boom has given the average retail investor the ability to add some "alternative" bond types to a portfolio. The previous ideas are great ways to play the current difficult environment for bonds.

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