The world of fixed income ETFs has been expanding over the last two years, and everyone from professionals to individual investors uses the products for exposure to bonds of all types. The asset class can be divided into four main sectors: U.S. government, corporate, municipal and international. All three have very distinct pros and cons, and the performance has not been consistent with each other.
U.S. Government Bond ETFs
The iShares family of bond ETFs currently is the leader with the most popular of the investment vehicles in the government space. The ETF most appropriate for the investor depends on the maturity the investor seeks. For example the iShares Barclays 20+ Yr Bond ETF (NYSE:TLT) invests in bonds with maturities greater than 20 years. The ETF was decimated in 2009, falling 25%, but has been able to gain back some of the losses in the first half of 2010. The yield on the ETF is 4.% and expense ratio is a low 0.15%. (For more, see A Fixed-Income Portfolio For The Masses.)

As the yield on the bonds fall, the price of the underlying bonds and the government bond ETFs increase in value. With the 30-year treasury yield near 4%, the probability of a move higher and a fall in bond prices is very likely. As a matter of fact, there is a bubble in the U.S. government bond market, and I'd look for opportunities in different areas sooner rather than later.

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Corporate ETFs
Instead of having the backing of the U.S. government, corporate bonds are debt-issued by publicly traded companies. The iShares iBoxx Corporate Bond ETF (NYSE:LQD) invests in a basket of investment-grade corporate bonds and currently offers a yield of 5.4%. Some of the companies' bonds that LQD holds include AT&T (NYSE:T), Goldman Sachs (NYSE:GS), and Wal-Mart (NYSE:WMT). LQD has had a strong 2010, similar to TLT. However, the major difference is that LQD was up 2.5% versus a big fall for TLT. (For more, see Bond Funds Boost Income, Reduce Risk.)

If more risk is appropriate, I suggest the SPDR High Yield Bond ETF (NYSE:JNK), which invests in below investment-grade corporate bonds often referred to as junk bonds. The volatility will be higher with JNK, but so will the potential reward and the current yield is 12.2%. JNK had a great year in 2009, gaining 20%; but the ETF is flat in 2010, lagging its peers. Even with the underperformance in 2010, JNK offers big upside along with a monster dividend yield. (For related reading, check out Dumpster Diving For Junk Bonds.)

Municipal ETFs
The word on the street is that municipalities around the country are having severe budget issues, but it has not had a big effect on the municipal bond ETFs. The iShares S&P National Muni Bond ETF (NYSE:MUB) pays a tax-free 3.6% yield and invests in a large basket of municipal bonds with a 0.25% expense ratio. Two benefits of MUB are the tax-free dividends and the low volatility. The ETF was up 3% in 2009, and has gained 1% in 2010.

My personal favorite in this sector is the Market Vectors High-Yield Muni ETF (NYSE:HYD), which invests 25% into investment-grade bonds and the remainder into municipal junk bonds. This increases the tax-free yield to 5.1% and amazingly the volatility does not rise accordingly. Over the last few months, the ETF has remained within a 2% trading range, but is up 18% since it began trading in February 2009.

International ETFs
To further diversify a bond portfolio it is essential to include international bond ETFs. The SPDR International Treasury Bond ETF (NYSE:BWX) is made up of over 100 foreign bonds with a yield of 3.8%. Countries represented include Japan, Italy and the U.K.

The higher risk, higher reward play is the PowerShares Emerging Markets Sovereign Debt ETF (NYSE:PCY). The ETF has a dividend yield of 6.1% and gives investors exposure to countries such as Bulgaria, Uruguay, Brazil and Russia. After gaining 27% in 2009, the ETF is up another 3% in 2010, making it one of the best performers in the entire asset class.

The Bottom Line
The key to building a solid long-term bond portfolio is diversity. Investors should have exposure to all the above-mentioned sectors, and could even go into individual bonds if the situation is appropriate. (For more, see Exchange Traded Funds: Fixed-Income And Asset-Allocation ETFs.)

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