by Ken Hawkins

Although the first exchange-traded funds (ETFs) were developed for equities, ETF providers have branched out into bond ETFs and asset allocation ETFs, such as those that contain different asset classes.

Fixed Income ETFs
The bond market is not as liquid or transparent as the equity market. Also, unlike stocks, bonds do not trade on an exchange. Bond ETFs can be as liquid and transparent as stock ETFs and trade on a stock exchange.

In a stock ETF, the fund is generally composed of all the stocks in the index. This is not the case in most bond ETFs. The fund holds a fraction of the bonds that make up the underlying index. Bond prices are relatively straightforward - they are a function of the risk-free rate, the coupon, the quality of the bond and the years to maturity. Using those factors, the managers of a bond ETF use a sampling technique that allows them to closely duplicate the performance of the underlying bond index.

Bond ETFs pay out interest through a monthly dividend, while any capital gains are paid out through an annual dividend. For tax purposes, these dividends are treated as either interest income or capital gains.

Broad-Based Bond ETFs
As with a stock ETF, investors can buy a broad-based bond ETF containing a broad mix of both government and corporate bonds at different maturities. A broad-based bond ETF can form a core component of a bond portfolio. An example is the iShares Lehman Aggregate Bond Fund (PSE: AGG).

Yield Curve Bond ETFs
Some bond funds allow investors to buy Treasury bonds based on different maturities along the yield curve. The longer Treasury ETFs are good for speculating on changes in interest rates, while the short-term bond funds are a good place to park money that typically provides a better return than money market funds. (For more insight, read Evaluating Bond Funds: Keeping It Simple.)

Examples of yield curve bond ETFs include:
  • iShares Lehman 1-3 Year Treasury Bond Fund (PSE:SHY)
  • iShares Lehman 3-7 Year Treasury Bond Fund (PSE:IEI)
  • iShares Lehman 7-10 Year Treasury Bond Fund (PSE:IEF)
  • iShares Lehman 10-20 Year Treasury Bond Fund (PSE:TLH)
  • iShares Lehman 20+ Year Treasury Bond Fund (PSE:TLT)

Inflation Protected Bond ETFs
Treasury inflation protected securities (TIPS) bonds pay interest equal to the Consumer Price Index plus a premium. They provide a hedge against inflation and are designed to outperform regular bonds when inflation expectation rises. Bond ETFs that provide protection against inflation own the TIPS. (For more insight, read Treasury Inflation Protected Securities.)

An example includes iShares Lehman TIPS Bond Fund (PSE:TIP).

Asset Allocation ETFs
Balanced mutual funds, or mutual funds that take a fund of funds approach, are common offerings for most mutual fund companies. However, ETFs that invest in different asset classes are relatively new. An ETF that contains investments in different asset classes allows an investor to buy one ETF and get a fully diversified portfolio.
Examples of asset allocation ETFs include: PowerShares Autonomic Balanced NFA Global Asset Portfolio (AMEX:PCA) PowerShares Autonomic Balanced Growth NFA Global Asset Portfolio (AMEX:PTO)
Target Date ETFs
Target date (or life-cycle) funds have become very popular funds for mutual fund companies, especially for companies targeting the defined contribution pension plan market. Recently, ETFs have been created with the same feature as the target date mutual funds. Target date funds are essentially balanced asset allocation funds with one additional feature - they become more conservative as they approach the target date. Funds will reduce risk by selling stocks and buying bonds as the target date approaches. (For more insight, read The Pros And Cons Of Life-Cycle Funds.)

While saving for retirement is the main reason investors buy target-date ETFs, the funds are designed for any savings goal that has a targeted end date. They were created for investors who do not want to manage their investments. An investor can simply buy one ETF for the targeted retirement date and not have to make any more decisions about that investment.

Examples of target date ETFs include:
  • TDAX Independence 2010 ETF (PSE:TDD)
  • TDAX Independence 2030 ETF (PSE:TDN)
  • TDAX Independence 2040 ETF (PSE:TDV)

Next: Exchange-Traded Funds: ETF Alternative Investments »

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