Treasury bond yields are now near their all-time lows as the fears over global economic slowdown continue to push the investors towards “safe haven assets”.
The benchmark 10-year note yield is now touching 1.61% and thus investment in these bonds is almost guaranteed to result in loss of principal in real terms since the inflation rate is close to 2%. (Read: Top Two Emerging Market USD Bond ETFs Head-to-Head)
In its efforts to stimulate the economy, the Fed has kept the short-term interest rates near zero since late 2008 and it expects the rates to stay at these levels at least through late 2014.
Additionally, it has bought more than $2 trillion in bonds to keep the long term interest rates low. After its FOMC meeting last week, the central bank decided to extend the Operation Twist through the end of the year.
The Fed also downgraded its outlook for the GDP growth and reiterated that it stands ready to take more action (including additional bond purchases) if the labor market weakens further. (Read: Follow Buffett With These Developed Market Bond ETFs)
During the press conference after the meeting, the Fed chairman Bernanke stated that by buying Treasuries, the Fed is actually encouraging the investors to buy other assets like corporate bonds.
While the short-term rates are already at near zero levels, the longer-term rates and corporate bond yields could go lower in the coming months due to Fed action.
According to some studies, the long-term rates fall 0.03% or a bit more for every $100 billion of long-term bonds that the central bank purchases.
As the Euro-zone continues to be a mess, recovery in the U.S. seems to be stalling and emerging economies are going through worse-than-expected slowdown, the rates do not seem to be going up anytime soon though they will have to go up eventually. Also, inflation does not seem to be a concern as of now.
Further, If the European situation does not improve substantially, there is a good chance that government bonds and high quality corporate bonds may outperform the stocks over the next six months to one year period. (Read: Play Europe with This ETF Pair Trade)
What does this mean for the fixed income portfolios of investors and how can the investors take advantage of decline in rates with an investment horizon of about one year in mind?
With the Treasury bonds yielding paltry returns (in nominal terms), the retail investors should instead consider buying high quality corporate bonds, which provide significant yield pick-up with only a slight increase in risk.
Due to solid balance sheets and high cash levels of the investment grade US corporates, the chances of default are very-very low. Thus the investment-grade corporate bonds can be considered near-safe as far as credit risk is considered.
Further if the global economic situation worsens leading to further “flight to quality”, the high yield bonds will suffer much more than the investment grade bonds.
ETFs are the most convenient and inexpensive way to gaining exposure to Investment grade corporate credit and the investors have a choice of many ETFs available to them. The investors should however remember that unlike individual bonds which return principal on the maturity date, most bond ETFs do not have a maturity date and principal value will continue to fluctuate during the period of holding.
iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD)
Launched in July 2002, the fund has attracted more than $22 billion in assets so far and is the largest and most liquid ETF within this space. The ETF currently holds 957 securities and charges a low 15 basis annually to the investors for its expenses. Financials (36.4%), Consumer Services (12.3%) and Oil & Gas (10.6%) occupy the top spots in terms of sector breakdown. Average maturity of the holdings is 11.9 years, while the effective duration is 7.49 years.
12 month distribution yield is 4.14% currently. The fund has gone up 3.07% year-to-date, after an impressive 8.89% rise in 2011.
PIMCO Investment Grade Corporate Bond Index Fund (CORP)
CORP seeks to match the total return of BofA Merrill Lynch US corporate Index, which is comprised of U.S. dollar denominated investment grade, fixed rate corporate debt. Top five industries are Banks (15%), Electric Utility (7%), Brokerage (7%), Pharmaceuticals (5%) and Integrated oil (5%). Launched in September 2010, the fund currently has $256.9 million in AUM, which it holds in 190 holdings.
Average effective maturity of the fund is 9.4 years and the effective duration is 6.3 years. 12 month distribution yield is 3.21% currently. The ETF charges 0.20% in expenses and has returned 4.95% year-to-date and 9.07% over one-year period. The fund has assigned 72% weight to US, 6.5% to UK and 3.4% to Canada.
iShares Barclays Credit Bond (CFT)
CFT seeks to track investment grade credit sector of the bond market, as defined by Barclays US Credit Bond Index. The fund has 1880 holdings with a weighted average maturity of 9.91 years and an effective duration of 6.41 years. ETF has assigned heaviest weight to Industrial sector (43%), followed by Financials (23%) and Utilities (9%).
Launched in January 2007, the fund has attracted $1.29 billion in AUM so far. The expense ratio is 20 basis points per year and the 12 month yield is 3.87% currently. The fund has returned 1.89% year-to-date, after 8.05% return in 2011.
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