Bond ETFs: A Magnet for Investors Seeking Flexibility and Safety

With the stock market continuing to show extreme volatility this year, many investors are shifting more of their money out of stocks and into bonds and other fixed-income investments. As they make the move, they're considering bond exchange traded funds as a way to enhance their overall investment strategy.

The assets of fixed-income ETFs increased by 21%, or $21.2 billion, in the first half of 2010, maintaining a strong pace of growth after jumping by 78% in 2009. According to S&P, fixed-income ETFs currently account for $122 billion of the $772 billion total U.S. ETF market, and that share is expected to increase.

"There is an appetite coming from actively managed mutual funds and other sources, in addition to some rotation from equity ETFs to fixed-income ETFs," says Ken Leon, vice president of S&P Equity Research.

ETFs Springing Up in Many Bond Categories

When equity market returns are low or extremely volatile, investors often move money to fixed-income investments, which are generally more conservative and considered safer than stocks. The shift to bond ETFs is also being fueled by investor fears stemming from equity losses suffered in a choppy market environment, which has featured several 200-plus point market dives this year, including this week's 265-point drop on Wednesday. Uncertainty over the reoccurrence of an event such as the May 6 "flash crash" also has investors looking for ways to exit investments quickly -- something ETFs provide.

As fixed-income ETFs become more popular, ETF providers are sure to create more of them -- currently only 105 of the roughly 900 ETFs in the market are devoted to fixed income. New entrants spring up in many bond categories, including corporate, Treasury, Treasury Inflation Protected Securities (TIPS), high yield, foreign, government agency, municipal and many subcategories within those groups. Investors should be clear about what type of bonds are in the ETF they're purchasing and how those securities fit into their portfolio's asset allocation.

Both bond ETFs and bond mutual funds give investors exposure to the broad bond market. For more active investors, an ETF may be a better choice than a mutual fund. ETFs can be traded at any point during the trading day -- desirable if investors want to react quickly to market swings -- while mutual fund orders are executed at the end of each trading day when the final net asset value of the securities in the fund is calculated.

Making the Right Picks

When determining which bond ETFs to purchase, Leon says investors should make sure their picks meet the same objectives for similar fixed-income investments within their retirement plan or investment portfolio. For instance, if they have a diversified mix of fixed-income mutual funds in their portfolio, they should select a diversified mix of ETFs that mirror the same style and approach.

Leon also cautions investors to check the liquidity of the ETF -- does it have a healthy asset base, and is there regular trading volume? Asset size and trading volume become very important as more providers offer ETFs that track the same types of bonds. Low trading volume may result in the ETF not reflecting actual market prices for the securities, or it may suggest a lack of interest from investors, which can cause the ETFs to close.

"If you're in the larger fixed-income ETFs that have sufficient average trading volume, you're going to be fine," says Leon. But he adds: "Trying to buy or sell and get the right price on some of the smaller fixed-income ETFs from some of the smaller providers can get more problematic."

Although ETFs are generally low in cost, investors should still compare operating expense ratios, as well as factoring in any commission fees they may be assessed. While there's a trend toward firms offering ETFs with no commissions on trades, it's not yet universal.

Some Strong ETF Performers

And, of course, Leon says investors should consider the performance of the ETF they want to buy. Although they're constructed to track indices, certain types of bond ETFs may perform quite differently under different economic conditions. According to State Street Global Advisors, investors poured more money into short-term bond and U.S. Treasury bond ETFs in the first half of 2010, boosting their inflows by $7 billion and $5 billion respectively.

For in the second half of 2010, Michael Iachini, the director and investment manager of research for Charles Schwab Investment Advisory, expects different categories of bond ETFs to do well.

"We do have a slight overweight to corporate and high-yield bonds," says Iachini, who uses ETFs for broad, strategic diversification in client portfolios. "The view is that over the next 6 to 12 months, the return potential of corporate bonds looks pretty good compared to Treasury bonds. We aren't overly concerned about a double dip that might cause them to drop in value, so we like the extra yield you can get and we think the downside is well contained."

Last month, Morningstar suggested a diversified bond ETF portfolio for investors, and Barron's offered five select bond ETFs it felt would perform well in the second half of 2010.

The two largest bond ETFs that track the broader bond market, iShares Barclays Aggreegate Bond ETF (AGG) and Vanguard Total Bond Market ETF (BND) were endorsed by both Barron's and Morningstar. Although it has less than a half-billion in assets, Barron's offered the Powershares Build America Bond ETF (BAB) as a strong choice because of its yield.