Understanding Bond ETFs
One reason for the explosive growth of the ETF industry is that ETFs have dramatically expanded the way that investors can buy bonds and other fixed income securities.
The bond market is different than the stock market
Bond market ETFs are different in many respects than stock market ETFs, because the bond market is different than the stock market. Many bonds are not actively traded, partly because many investors buy a bond when it is issued and hold it until maturity.
Bonds are also different than stocks because they are traded over the counter and not on an exchange. There are several reasons why most bonds are traded over the counter, including the fact that bonds are very diverse. Stocks have only two types, common stock or preferred stock, and are limited to a few characteristics. Bonds on the other hand, have different qualities, maturities and yields. The outcome of this diversity is more issuers, and issues of bonds with different characteristics, which makes it difficult for bonds to be traded on exchanges.
Another reason why bonds are traded over the counter is the difficulty in listing current prices. It might have been months since the last trade of a particular bond. With changing interest rates, it is more difficult to determine a current market value of a bond.
Bond indexes are also different than stock market indexes because bond indexes often contain thousands of individual bonds. The Bloomberg Barclays U.S. Aggregate Index is one of the most widely followed bond indexes, because it tracks the entire U.S. bond market, including both government and corporate bonds. As of August 31, 2016, there were over 9,900 securities in the index, hundreds of which are thinly traded. Given the limited number of times that many of these bonds are traded, it is virtually impossible for an ETF to buy all of the bonds in the Bloomberg Barclays U.S. Aggregate Index.
Most bond ETFs that are tracking an index attempt to track their index using "index sampling". Index sampling means that the portfolio manager of the ETF will judgmentally decide to purchase enough bonds that are similar in characteristics to the bonds in the index the ETF is tracking, so that hopefully the investment results of the ETF will closely mirror that of the index (before expenses).
The investing public seems to have come to grips with the notion of an actively managed bond ETF, much more so than with an actively managed stock ETF. Perhaps because in a way, it is sometimes hard to believe that there is a lot of difference between a portfolio manager who is judgmentally picking bonds to buy in order to track an index using "index sampling" and a portfolio manager who is judgmentally picking bonds to buy with an actively managed bond ETF.
Perhaps the biggest difference between an actively managed bond ETF and an index bond ETF is that an investor probably has more assurance that the index bond ETF will not stray from their primary investment objective. An index ETF that is seeking to track a corporate bond index generally must use 80% or 90% of their assets to purchase the corporate bonds in the index. An actively managed bond ETF that normally purchases corporate bonds may have an investment policy that allows the ETF to purchase other types of bonds, besides corporate bonds, at the discretion of the portfolio manager. In either case, you have to read the ETF's prospectus to understand each ETF's exact investment policy.
Understand the effect of changing interest rates
As a general rule, when interest rates go up, the value of a bond (and thus a bond ETF) will generally go down. Conversely, when interest rates go down, the value of a bond will go up. This rule of thumb becomes more pronounced with long term bonds. The longer the maturity of the bond, the more likely that the value of the bond with go up or down as interest rates change.
The U.S. has experienced a twenty year period of declining interest rates. So as an asset class, bonds have performed very well the past twenty years, because they got a boost from a long-term trend of declining interest rates. So every investor is worried about what will happen to bonds if and when interest rates rise. You can read more about this topic by reading our article ETFs for rising interest rates.
How do you know how much a particular bond ETF will be affected by rising interest rates? It is not perfect, but one tool we use is to look at the correlation of a bond ETF's price performance to the price performance of TNX, the CBOE Ten Year Treasury Note Yield Index.
Let's look at an example. AGG, the iShares Barclays Aggregate ETF, has a correlation to TNX, the CBOE Ten Year Treasury Note Yield Index, of -0.9495. A negative correlation means that as ten year treasury yields have gone up, the value of AGG has tended to go down. Any negative correlation over 90% is a strong one.
Let's look at another example. BKLN, the PowerShares Senior Loan Portfolio ETF, has a positive correlation to TNX of 0.5090. A positive correlation means that as ten year treasury yields have gone up, the value of BKLN has generally also gown up. BKLN is a somewhat unique fixed income ETF because it buys bank loans, which typically are structured with floating interest rates. That explains why it has less sensitivity to changing interest rates than most bond ETFs.
Correlation is a statistical calculation. Generally speaking, any correlation, either positive or negative, that is less than 70% to 80% is generally considered to be a weak correlation. So BKLN's positive correlation of 0.5090 should not be interpreted too strongly. A statistician would probably say that a correlation of 0.5090 is so weak that there is no real meaningful relationship between TNX and BKLN. The best way to think of it is that at least BKLN does not have a strong negative correlation, like AGG.
Bond ratings
When a bond is first issued, it is given a rating by one of three bond rating agencies: Fitch, S&P and Moody's. The rating agencies look at the financial health of the bond issuer and try to determine how likely it is that the issuer will be able to honor its commitment to make payments on the bond in a timely fashion. Bond ratings are expressed as letters ranging from "AAA," which is the highest grade, to "C" or "D", which is the lowest grade. The different rating services use the same letter grades, but use various combinations of upper and lower-case letters to differentiate themselves.
Obviously, a bond issuer wants their bonds to receive the highest rating, because it will be easier to sell the bonds and the interest rate on the bonds will be lower if the bonds receiver a higher rating. But the key divide is to receive a rating above Ba1/BB+/BB+, so that the bonds will receive a grade of "investment grade". Bonds rated Ba1/BB+/BB+ or below are considered to be "high yield" bonds or "junk bonds".
Most investors allocate most of their bond portfolio to investment grade bonds. So many of the most popular bond indexes, like the Bloomberg Barclays US Aggregate Bond Index, are composed of investment-grade quality or better bonds.
Understand high yield bonds
So the key divide in the bond market is whether a bond is an investment grade bond or a high yield bonds. The two asset classes perform quite differently.
Since the interest rates on investment grade bonds are substantially lower than high yield bonds, the dividend yields of AGG and JNK are substantially different:
| Symbol | Description | Historical average yield |
|---|---|---|
| AGG | iShares Core U.S. Aggregate Bond ETF | 3.08% |
| JNK | SPDR Barclays High Yield Bond ETF | 7.06% |
The high yield bond market is really a separate market from the investment grade bond market. The high yield bond market ebbs and flows as investors worry about the economy, which can affect the default rates on high yield bonds, and as investors change their attitudes about how much risk they are willing to take on.
As a result, the interest rates on high yield bonds move somewhat independently of overall current interest rates.
So the difference, or "spread", between current interest rates on investment grade bonds versus the interest rates on high yield bonds is constantly changing. BAMLH0A0HYM2, the BofA Merrill Lynch US High Yield Option-Adjusted Spread Index, measures this difference.
Data on the BofA Merrill Lynch high yield indexes courtesy of the Federal Reserve Economic Data, or FRED, system.
So the value of a high yield bond ETF like JNK is dramatically affected by the changing spreads in the high yield bond market. As the spread narrows, the value of JNK will go down.
Another way to analyze this is to look at the correlation to TNX, the CBOE Ten Year Treasury Note Yield Index, of AGG and JNK:
| Symbol | Description | Correlation to TNX |
|---|---|---|
| AGG | iShares Core U.S. Aggregate Bond ETF | -0.95% |
| JNK | SPDR Barclays High Yield Bond ETF | 0.37% |
High yield bonds are generally believed to perform better than most bonds in a rising interest rate environment. The average correlation to TNX of the 64 U.S. high yield bond ETFs is -0.15. A positive correlation is important, even if it is not a very strong one, because most bond ETFs have a negative correlation to TNX (as interest rates rise, the value of the bond ETF should go down).
Why are high yield bonds less affected by rising interest rates? There are really three reasons for that.
First, interest rates normally rise as the U.S. economy expands. That can be a good thing for high yield bonds because the expanding economy should generate more profits for most companies, and with increased profits, most companies can better service their debt. So in an expanding economy, default rates on high yield bonds should decline.
Second, many high yield bonds include call protection. When rates are about to rise, companies are more likely to try to take advantage of lower rates and refinance their debt before rates increase. Many high yield bonds include a call price, or pre-payment penalty, if the company refinances its debt before maturity. This pre-payment penalty adds to the returns of a high yield bond.
Third, the duration of high yield bonds is typically lower than investment grade bonds due to high yield's relatively short maturity and high coupon rates.
Understand global fixed income
One of the biggest risks related to a global fixed income ETF that invests in bonds issued in a local currency is that the value of the ETF's holdings (and thus the market price of the ETF) will be significantly affected by changing U.S. dollar exchange rates. Most investors have little idea what drives currency exchange rates, and are unable to predict whether U.S. dollar exchange rates will go up or down over the next five years. So global fixed income ETFs that buy local currency bonds are much riskier investments, as an investor is taking on a foreign currency risk that is difficult to analyze.
Theoretically, over long periods of time, the U.S. dollar's exchange rate with developed market currencies round the world should be flat. For example, over long periods of time, the U.S. dollar exchange rate with the Euro should theoretically equal out: sometimes the exchange rate is high and sometimes it is low, but you wouldn't expect a long-term trend of the Euro declining against the U.S. dollar, unless Europe experiences significant economic problems.
It is much harder to know what happens over long periods of time with the U.S. dollar's exchange rate with emerging market currencies. Emerging market countries are "emerging markets" for a reason, with potentially unstable governments and economies and unknown long-term inflation rates. It is very possible that over long periods of time, the U.S. dollar's exchange rate with many emerging market countries may strengthen. That means that if you buy a global fixed income ETF that buys emerging market bonds denominated in the local currency, you are potentially pushing a cart uphill, as the value of your investment may go down as the U.S. dollar strengthens.