Top 5 Bond ETFs

By Ryan C. Fuhrmann | February 07, 2013 AAA

In a recent memo to clients, Oaktree Capital Management Chairman Howard Marks observed that, in many cases, the yields (coupon rate divided by the current market price) on bonds are hovering around their lowest levels "in our nation's history." That may cause many investors to consider why they are invested in bonds at all. But there are still many valid reasons why fixed income investing is an essential part of an overall asset allocation program.

The biggest reason is that bonds are less volatile than stocks and can therefore be less risky investments. A recent article by Morningstar, a financial services and research firm, pegs the annual standard deviation (a standard industry measure of risk) for bonds over the last decade at only around 4%. This is much lower than the average stock market standard deviation of 15%.

That being said, bond rates are still very low and make it much more difficult for investors to earn a sufficient return on their investment. As a result, investing in bonds through low-cost exchange traded funds (ETFs) can really make sense. Their lower expense ratios compared to mutual funds and other alternatives can help an investor keep a bigger chunk of the income a bond generates. Below are five top bond ETF options for investors to consider.

SEE: Bond Basics

iShares Core Total U.S. Bond Market ETF
This ETF (ARCA:AGG) recently weighed in with a 30-day SEC yield of 1.66%. It is rather safe and liquid. It boasts nearly $15 billion in total net assets and carries a rock-bottom expense ratio of 8 basis points (BPS), or 0.08%. This means investors keep most of the yield. The weighted average maturity of the bonds held in the ETF is 6.5 years, and the top holdings are U.S. Treasury bonds and notes, which are considered risk-free because they are backed by the U.S. government.

The ETF is built to closely match the performance of the Barclays U.S. Aggregate Bond Index. This is a safer index that invests in the U.S. investment-grade bond market, including highly-rated government, corporate and asset-backed securities. The tradeoff to this safety is a lower yield, but investors should sleep more soundly at night, given that the holdings are considered some of the safest in the bond space.

SEE: Strong Bond ETFs In A Bond-Eroding Economy

iShares Barclays TIPS Bond ETF
Investors can lose out by investing in bonds if interest rates or inflation increase. Those concerned about the risk of higher inflation may want to play it safe by investing in the iShares Barclays TIPS Bond ETF (ARCA:TIP). The ETF invests in inflation-protected Treasury bonds, combining the advantages of investing in bonds backed by the U.S. government that will see yields rise if inflation perks up going forward.

The tradeoff for this risk aversion is that the current 30-Day SEC yield is negative 4.2%. The weighted average maturity is still relatively low at less than nine years, and the average return for this ETF over the past five years has been solid at 6.89%, but it has benefited from rates falling over this time period. To benefit in this ETF going forward, inflation will have to increase markedly. The expense ratio is quite reasonable at 0.2%.

SEE: Best ETFs For An Early Retirement

PIMCO 0-5 Year High Yield Corp Bond Index ETF
This ETF (ARCA:HYS) seeks to match the Bank of America Merrill Lynch 0-5 Year US High Yield Constrained Index. Investors must be careful investing in the high-yield bond space, which is a clever way to describe investing in junk bonds. But with an improving economy and comfort level that the underlying bonds have a lower risk of defaulting, investing in the space can make sense. Note that investors have been piling into high-yield bonds to stretch for yield, but this ETF still has a decent reported 12-month yield of 5.41% and reasonable expense ratio of 0.55%.

Vanguard Intermediate-Term Corporate Bond
This Vanguard ETF (Nasdaq:VCIT) offers low-cost exposure to corporate bonds with maturity dates out an average of seven years. Investment giant Vanguard is also a champion of offering low-cost investment options, and the VCIT doesn't disappoint. It has an expense ratio of only 12 BPS (0.12%). The 30-day SEC yield is 2.59%; above what investors are likely to find with shorter-term ETF alternatives.

Vanguard Long-Term Bond
Another worthy Vanguard ETF is the Vanguard Long-Term Bond Index ETF (ARCA:BLV). Again, the expense ratio is extremely low at 11 BPS (0.11%). Investors will also appreciate the 30-day SEC yield of 3.71% but must realize this is truly a long-term bond ETF. The average effective maturity is just over 24 years. This will boost yields, but it could also mean losses if interest rates increase from current levels going forward.

SEE: 5 Misconceptions About ETFs In Retirement Accounts

The Bottom Line
New bond ETFs continue to roll out into the marketplace. Continue to track the ETF giants, including Barclays and Vanguard, for new offerings. In the meantime, the above ETF options should offer broad appeal for a number of different angles, including shorter-term funds, those offering some inflation protection and higher-yield alternatives from moving into junk bonds or moving out on the maturity horizon.

At the time of writing, Ryan C. Fuhrmann did not own any shares in any company mentioned in this article.

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