Thursday, April 13, 2017

Why I Am Leery Of Bond ETFs

Since the 2007-09 financial crisis investors have been on a relentless search for yield in a period where interest rates have declined to historically low levels.  What this has done has forced investors out along the yield curve in terms of duration.  That is investors have been forced to go farther out in time for any sort of meaningful yield.  Today the ten year US treasury bond yields 2.26%.~  The historic rate for that bond has probably been around 5% and you need to go back to the late 1940s and early 1950s to find a time when bonds yielded so little.   For that reason I have been and continue to be leery of bond ETFs.  The chart above from a website called "bps and pieces" shows how investors in search of yield have pushed both the duration out and the yield down on the Bloomberg Barclays US Aggregate Bond Index {AGG}.  According to the article, the duration today is 20% higher and the yield 20% lower than it was eight years ago.  While I have not analyzed other bond related ETFs, it is likely they have experienced the same circumstances as the AGG unless they are specifically mandated to keep their duration to a certain period of time, say under seven to ten years.  At some point as interest rates rise, these ETFs with longer durations are at risk because their prices in theory should decline as interest rates decline.  The reason for this is that the underlying value of their current bonds should decline to compete with the yields on higher rates.  For those of you new at this bond prices in general decline as yields rise and prices rise as yields decline.  I don't have time to go into all of this today.  Just trust me.  Historically that's how it works and has a high probability of working in the future.

ETFs the most at risk for a decline in the underlying value of the securities in their portfolios are those with holdings where the maturities are going to occur many years in the future.    If you own or are considering buying fixed income ETFs know what's in the underlying portfolios.  The math for ETFs also works for bond related mutual funds.

Now the other side of that equation is that as interest rates rise then ETFs or funds with shorter duration may start to look more attractive.  Just remember that it may be wise for you to keep your duration or time period short, perhaps under ten years.  Of course this is a general overview and should not be considered investment advice.  You need to understand your own unique financial considerations before acting on anything you read here or anyplace else.  I would suggest you talk to your financial advisor or do your own homework first before implementing any new fixed income strategy.  

Next week is tax week.  I expect to be busy the first part of the week helping clients with last minute issues related to their return.  As such I may not post until the middle of the week depending on my time requirements.  It is amazing to me how many things come over the transom just prior to the filing date. 

~Treasury information is from Bloomberg Markets.

*Long certain bond mutual funds and a few bond related ETFs in legacy accounts.