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Fixed income can be a critical part of nearly every well-diversified portfolio. Used correctly, fixed income can add diversification and a steady source of income to any investor’s portfolio.
But how do you choose the right fixed-income ETF?
The key to choosing the right fixed-income ETF lies in what it actually holds. U.S. bonds or international bonds? Government securities or corporate debt? Bonds that come due in two years or 20 years? Each decision determines the level of risk you’re taking and the potential return.
There are many types of risks to consider with bond investing. Let’s talk more about two in particular: Credit risk and Interest-rate risk.
Determining the level of credit risk you want to assume is an important first step when choosing a fixed-income ETF. Do you want an ETF that only holds conservative bonds—like bonds issued by the U.S. Treasury? Or do you want one holding riskier corporate debt? The latter may pay you a higher interest rate, but if the company issuing the bond goes bankrupt, you’ll lose out.
ETFs cover the full range of available credit. Look carefully at the credit quality composition of the ETFs underlying holdings, and don’t be lured in by promises of high yields unless you understand the risks.
Bonds are funny. Intuitively, you would assume that higher interest rates are good for bondholders, as they can reinvest bond income at higher prevailing interest rates. But rising interest rates may be bad news, at least in the short term.
Imagine that the government issues a 10-year bond paying an interest rate of 2%. But shortly thereafter, the U.S. Federal Reserve hikes interest rates. Now, if the government wants to issue a new 10-year bond, it has to pay 3% a year in interest.
No one is going to pay the same amount for the 2% bond as the 3% bond; instead, the price of the 2% bond will have to fall to make its yield as attractive as the new, higher-yielding security. That’s how bonds work, like a seesaw: As yields rise, prices fall and vice versa.
Another important measure to consider when looking at interest rate risk is duration which helps to approximate the degree of price sensitivity of a bond to changes in interest rates.
The longer the duration, the more any change in interest rates will affect your investment. Conversely, the shorter the duration, the less any change in interest rates will affect your investment.
Let’s review a few other considerations when looking at fixed income ETFs.
First, expense ratios: Because your expected return in a bond ETF is lower than in most stock ETFs, expenses take on extra importance. Generally speaking, the lower the fees, the better.
Second, tracking difference: It can be harder to run a bond index fund than an equity fund, so you may see significant variation between the fund’s performance and the index’s returns. Try to seek out funds with low levels of tracking difference, meaning they track their index well.
Finally, some bonds can be illiquid. As a result, it’s extra important to look out for bond ETFs with good trading volumes and tight spreads.
There are other factors to watch for too, but these are the basics. ETFs can be a great tool for accessing the bond space, but as with anything, it pays to know what you’re buying before you make the leap.
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