Bond ETFs in a Rising Rate World?

02/07/2017 9:00 am EST

Focus: DIVIDEND

David Fabian

Managing Partner, FMD Capital Management

A reader recently sent me a question asking why you would own a bond fund when interest rates are on the move higher, notes David Fabian, money manager and editor of The Flexible Growth & Income Report.

The short answer is that every diversified portfolio should have bond exposure to balance out the risk of other asset classes -- i.e. stocks and commodities. 

Bonds have historically provided a shock absorber for the equity side of the portfolio and have not shown any signs of relinquishing that trait. 

Simply letting go of all your bond exposure will unnecessarily tilt your risks and returns towards a single outcome. It's like driving without a seat belt on. Everything will be fine, until it's not.

Here are three core bond ETFs that are coping well with rising rates:

Vanguard Short-Term Bond Index Fund (BSV)

If your goal is low cost and index-like returns, you can't go wrong with a fund like BSV.  This Vanguard ETF takes the approach of significantly shortening the duration of its holdings versus a traditional intermediate-term benchmark.

BSV has an effective duration of 2.8 years versus 5.9 years in BND. Remember that effective duration is essentially the measure of a fund's sensitivity to interest rate fluctuations.

BSV charges an ultra-low expense ratio of just 0.06%, has exposure to 2,400 underlying holdings, and nearly $20 billion in assets under management.

The portfolio is allocated using similar sector exposure to the Barclays Aggregate index, with the majority of holdings rated as high credit quality.

The downside to BSV is going to be its meager income stream. The fund currently sports a 30-day SEC yield of just 1.69% and income is paid monthly to shareholders. Such is the trade-off of lowering price volatility at the expense of the dividend payments.

SPDR Doubleline Total Return Tactical ETF (TOTL)

TOTL is an excellent selection for those that want an active approach to fixed-income. This fund is managed by Jeffrey Gundlach of DoubleLine Capital using a multi-sector approach to its asset allocation. It's a fund that I currently own for myself and clients of my wealth management firm.

The advantage of an active fund like TOTL is that it has more flexibility in security selection and risk management capabilities than an index. 

The fund manager can increase or decrease the effective duration, as well as shift assets towards areas of the bond market they feel offer greater value. There are also limits (or guidelines) on sector exposure that make this fund suitable as a diversified core holding.

Right now, TOTL yields 3.02% and has an effective duration of 5.02 years.  It also carries exposure to bank loans, emerging market debt, and other asset backed securities that you won't find in many benchmarks.

It's worth pointing out that TOTL charges an expense ratio of 0.55%, which is significantly higher than a passive ETF. 

As an active fund, it is also susceptible to underperform its benchmark if its positioning doesn't blend well with the fixed-income environment.

Nevertheless, this fund has weathered the recent jump in interest rates in a much smoother fashion than its peer group.

PIMCO Total Return Bond ETF (BOND)

PIMCO has always been a leader in fixed-income and its flagship total return bond fund continues to perform at a strong pace. The most interesting thing about BOND is its use of futures and currency swaps to manage risk. 

The portfolio is currently balanced between conventional U.S. fixed-income exposure paired with interest rate hedges, inflation protected bonds, and emerging market debt.

Over the last six months, this has led to diminished price volatility versus the Barclays benchmark. PIMCO takes a team approach to its credit and security selection criteria within the BOND portfolio as well. 

The effective duration is currently 5.71 years with a 30-day SEC yield of 2.70%. Its objective has always been one of a core holding for investors to utilize in lieu of a diversified index. Furthermore, the fund charges a similar expense ratio to TOTL at 0.56% annually.

Subscribe to David Fabian's The Flexible Growth & Income Report here.

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