Building a Fixed Income portfolio with ETF’s

By: ispeculatornew
Date posted: 06.23.2010 (4:08 am) | Write a Comment  (13 Comments)

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A few years ago, having a fixed income portfolio was possible if:

a) You were a large institution

or

b) You were willing to incur huge costs.

Why? Because Bonds and other fixed income instruments do not trade on listed markets. They are also traded through huge volumes. That means buying and selling low volumes generally results in unfavorable prices. And since you do not have access to “closing prices” or intra day graphs on most of these bonds, you really do not know how much commissions you are ending up paying to your broker/financial adviser when  they do fixed income transactions.

There was also the possibility of buying mutual funds that build bond portfolios. But as you hopefully know by now, I’m not a big fan of mutual funds and all of the costs incurred through them every year makes it only slightly better than trading the outright bonds. Of course when saying all of this, I’m speaking to individuals who have a smaller portfolio, maybe under 200K. If you are lucky enough to have a very large portfolio, trading the bonds outright is probably the easiest and cheapest way to go. For all of us not in that category, there is new hope….

A new era

But that is quickly changing with the arrival of many fixed income ETF’s . These ETF’s have much lower fees and are more tax efficient than similar mutual funds and are now diversified enough for investors to build a solid fixed income portfolio. No it’s not perfect yet and more ETF’s will be released to fill out the holes but I think that it is good enough to be the best solution for almost all investors looking to get a fixed income portfolios. Such a portfolio can provide good diversification but also be a good basis towards building a passive income.

Preferred shares ETF’s

It’s not 100% clear if Preferred Shares should be considered as fixed income or equity and honestly both could make sense. We have often included them as fixed income but not for this specific post. That being said, here are a few preferred share ETF’s in case you were interested:

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What should a fixed income portfolio include?

The basic fixed income portfolio would contain some Government bonds, Corporate Bonds and International. Bonds. Since every investor has different amounts to invest, I thought I would give two examples of portfolio structures that could be used. The first one is the simpler. A portfolio with less than 10,000$ or even a bit higher could use only 3 ETF’s and have some level of diversification and income. Here is what a very simple portfolio could look like (don’t worry, we’ll go over individual ETF’s later on):

Then, as you add more money, you can start adding more sub-classes that are an essential part of a fixed income portfolio. Even now, you can fill most of those classes with ETF’s. Without further waiting, here is a more complete portfolio example:

The Categories

Government bonds

Governments are by far the biggest bond issuers. They are generally reliable, have very very large amounts of debt (well beyond what any corporation would be able to borrow) and are able to easily issue bonds (except in specific cases such as Greece). Government issue bonds in many different ways and at all levels (National, State, Municipal, etc).

Treasury : These are the bonds issued by the US governments. They usually a pay a fixed interest coupon every 6 months. There are a variety of ETF’s that can be used to trade these but they often depend on the maturity you want to trade. More on that later on.

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Municipal : Municipal bonds are issued by local governments and have specific tax incentives that give incentives to own these. They usually also offer higher yields because local governments are seen as more risky. A good mix between treasuries and municipal bonds is usually a good way to gain additional return.

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Tips : These are government issued bonds that pay a floating interest. They are linked to inflation and pay more when inflation rises. Because of that, they are a good way for investors to hedge against inflation which can become a major worry for a lot of individuals especially when they are no longer earning income apart from their investments.

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Corporate

Corporate bonds are issued by all kinds of corporations such as General Electric, Microsoft, etc. These companies pay coupons and can   range from the best and wealthiest companies to those already in bankruptcy.

Investment Grade : These bonds were issued by companies that have very little risk of default according to the rating agencies. They pay smaller yields but also have very limited risk. Some of these companies even pay less than the Federal Government.

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High Yield : These bonds were issued by companies that have bad credit ratings and have a fairly high risk of default. They must pay very high yields to attract investors because of the higher risk associated with owning their bonds.

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International Bonds

It is always surprising to hear investors get such good diversification in equities but not look for the same with bonds. Granted, it is more complex and costly, but the diversification is worth it in my opinion. There are few ETF’s that fill this need but I would bet a lot that it will improve in the coming months

International Government Bonds: Foreign government often must offer much higher yields because of the risk involved. While bankruptcies can happen (Argentina and Russia were two major ones), a good fixed income portfolio should have some exposure to this sector.

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International Corporate Bonds: Many large corporations in Europe and Asia do not issue bonds in the US which provides opportunities to get more diversification by buying not only local corporate bonds but also international ones.

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Duration, Diversification, Ladder

Up until now, we have only looked at broad categories of bonds. More advanced investors would probably consider investing depending on the duration. The longer the bond has till maturity, the more sensitivity it has to interest rate movements (all other things being equal). Also, investors might have specific liquidity needs that will encourage them to look for bonds issuing near a specific date. For that reason, an increasing amount of ETF’s focus on the categories described above but for specific target dates.

Here is an example of bonds ETF’s offered by Claymore:

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13 Comments

  1. Comment by John — June 23, 2010 @ 8:22 am

    That’s great. For the Very simple FI portfolio, would you recommend to invest equally in each of the category? If not, what should based on to make a decision on the proportion?

    Thanks!

  2. Comment by The Financial Blogger — June 23, 2010 @ 8:42 am

    Hey IS, great post!

    However, sometimes too much info is like not enough info ;-). I mean, I would like to know who to build a sipmle and efficient portfolio. Which kind of percentage of each ETF should I include in my portfolio. How many EFT is enough to make sure I have a good portfolio.

    I’d like to read an article about how to build and manage a bond portfolio.

    thx!

  3. Comment by Craig — June 23, 2010 @ 9:22 am

    when purchasing Bond ETF, do you get the interest deposited in your account? how does it work?

  4. Comment by IS — June 23, 2010 @ 10:30 pm

    @John – No I would not. It would really depend on your profile and objectives. For example corporate bonds have a better return but more risk so a young investor would probably have more of those

    @TFB – interesting questions. Like I told John, the exact % would depend on your profile but for a retirement account I would be between 3 and 10 ETF’s. I will try to write more about that soon

    @Craig – Actually, these ETF’s pay back interest payments in the form of dividends either monthly or quarterly

  5. Comment by Rob — June 24, 2010 @ 2:00 am

    thanks for a great post. Question on the duration aspect. As an ETF we can buy and sell anytime… so why choose longer or shorter duration if the risk is roughly equal? e.g.,
    IEF iShares Barclays 7-10 Year Treasury Bond Fund 1yr return 9.077 DivYield 3.19
    IEI iShares Barclays 3-7 Year Treasury Bond Fund 1yr return 7.281 DivYield 2.3

  6. Comment by IS — June 24, 2010 @ 4:07 am

    @Rob – The risk is somewhat different. For example a 7-10 year treasury will usually have more duration = more interest rate risk. You would also be more dependent on the 10 year rates rather than short term.

    I agree, the difference is not that important between the two you are mentioning but when you want to invest according to specific interest rate movements, you might prefer over the other.

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  12. Comment by TAYLOR DAVENPORT — August 20, 2010 @ 9:31 am

    HOW EXCATELY IS AN ETF SOLD AND CAN THE MONTHLY DIVIDENDS BE HANDLED OR REINVESTED OR DEPOSITED IN YOUR BANK ACCOUNT OR BROKERAGE ACCCOUNT? THANKS

  13. Comment by IS — August 22, 2010 @ 8:18 am

    @Taylor – Do you mean selling short?

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