Can Bond ETFs Have Another Banner Year?

There's one word to describe the exchange-traded bond-fund business and market in 2009 -- booming. Can fixed-income ETF investors expect more of the same in 2010? Although assets in bond ETFs still pale in comparison to assets in bond mutual funds -- $99 billion versus $2.1 trillion as of November 2009 -- bond ETFs experienced an explosion of growth in 2008 and 2009, says Mike Benedict, a certified financial planner with Weaver Wealth Management. Indeed, last year more than $39 billion flowed into long-only bond ETFs as of Nov. 30, the most recent data available, according to the National Stock Exchange. Meanwhile, more than $26 billion fled long-only U.S. stock ETFs.%%DynaPub-Enhancement class="enhancement contentType-HTML Content fragmentId-1 payloadId-61603 alignment-right size-small"%% And no wonder: Investors seeking the comparative security of fixed income earned unusually strong returns last year. The Vanguard Total Bond Market ETF (BND), a proxy for the broader bond market, returned nearly 7% in 2009. Why the mad dash to bond ETFs? Historically low short-term interest rates, rising bond prices and ETFs' low-costs proved to be a seductive combination. "With very little money, ETF buyers were able to get a broad-based exposure to rising bond prices," explains Jim Behrmann, senior vice president for First Houston Capital.

Seeking Yield In A Low Interest Rate World

With short-term rates expected to stay at essentially zero for the first six to nine months of the 2010, there's reason to expect similar flow of funds. After all, investors are being chased out of near-zero yielding money market funds in search of better returns, says Mark Luschini, chief investment strategist for Janney Montgomery Scott.

It also helps that ETFs make bond buying much cheaper and easier for regular folks. "Buying individual bonds can be expensive since there are still significant mark-ups and mark-downs when buying small-ish quantities," says Bard Malovany, a wealth manager with Sagemark Consulting. "ETFs allow investors to purchase an index-like investment with low cost."

Furthermore, since ETFs are traded like stocks, bond ETFs can be sold short or traded using stop-loss orders and limit orders, adds Weaver Wealth Management's Benedict. Investors can also precisely target their investment to the economic sector, bond quality and bond maturity schedules that they feel are most attractive

However, fixed-income investors should have at least a rudimentary understanding of the approach taken by the ETF sponsor in constructing the bond portfolio. "Make sure that the index the ETF is attempting to proxy matches what you're seeking," cautions Janney Montgomery Scott's Luschini.

Know too that gains made through the buying and selling of bond ETFs are subject to the same capital gains taxes as stocks or mutual funds, says Behrmann. And while expense ratios tend to be lower than they are for the average bond mutual fund, you do have to pay a commission to your broker when buying or selling bond ETFs, says Brenda Wenning of Wenning Investments.

All Eyes on Fed in 2010

So will 2010 be as bright for bond ETF investors as 2009? A lot depends on the Federal Reserve, which has kept interest rates at historically low levels for an extended period to boost the economy. As the recovery plays out, the Fed may raise interest rates to stem future inflation. "As this process unfolds, bond prices, and therefore, bond ETF prices, will decline," Behrmann says.

For example, if rates do rise, longer maturity, lower grade bonds will lose more value than short-dated, investment grade paper. "If the ETF investor is in a broadly diversified fund with regards to maturities and quality, then he will suffer a greater loss than if he instead bough individual, short-dated, high-grade bonds or a short-dated, quality oriented ETF," says Behrmann.

Then there's the case that a number of factors pushing up bond ETFs in 2009 might not repeat themselves in 2010. For example, bond ETFs benefited from a general melt up in risk assets last year, as well as a recovery in prices from severely oversold conditions. "[Also] helping bond ETF returns has been the tsunami of new money coming into them which contributed to pushing prices higher," says Luschini.

The bottom line: Although investors should be thinking about bond ETFs for their strategic importance within a properly diversified portfolio, at the same time they should not ignore the macroeconomic environment in which bond ETF selections are made. "Fortunately, the inventory of bond ETFs that exist today should allow investors holding disparate opinions to invest for success with bond ETFs," Luschini says .
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