Fixed-income securities are a mainstay of investor portfolios. While they come in many shapes and sizes, bonds and other fixed-income securities are simple in principle—they're loans from the investing public to an institution that needs money. Issuers of the bonds are the borrowers, and investors are the lenders. Investors who lend the money expect to be repaid, and they expect to be compensated for the use of their money and the risk they take in making the loan. Investors' compensation—the interest on the loan—often takes the form of a regularly paid coupon, say, 5 percent per year. It's this coupon payment—a consistent, repeating cash flow—that gives fixed income its name.
The fact that bonds provide a steady cash return and eventually repay all of the original capital (assuming all goes well) gives them a unique role in a portfolio—they provide a steady flow of returns with lower volatility than equity. However, for years, bonds have been used as a counterbalance to equity investments for another reason: Historically when stocks go down, bonds often go up.
But why do bonds “go” anywhere? Don’t they pay regular coupons, as well as return the principal?
In fact, the value of the bond changes over time. Imagine that a hypothetical bond’s 5 percent coupon perfectly compensates the investor at the time of issue. The investor receives $5 per year for the $100 initially lent. But if inflation shoots up unexpectedly by 2 percent the year after the bond is issued, the same company might issue nearly identical bonds with a 7 percent coupon. Suddenly, last year’s bonds with their 5 percent coupons don’t look very attractive to investors. Since the coupon is fixed at 5 percent, the only thing that can reflect the bond’s disadvantage is its market price, which, in this example, will go down—let’s say to $98. The point here is that while the coupon of the bond is fixed, the bond’s value on the market—and in your portfolio—is not.
The relationship of a bond’s coupon to its current market price is captured in its yield. In our example, the yield of the bond paying the 5 percent coupon at the time it was issued was also 5 percent. But when the bond’s market value went down from $100 to $98, the bond’s yield went up. Intuitively, we know that the $5 coupon is more than 5 percent of the new, lower $98 value. The math is a bit more complicated than this, but the idea is that the yield of the bond expresses the value of the coupon payments relative to the current market price of the bond. When the bond’s market price goes down, its yield goes up, and vice versa.
Fixed-Income ETFs: The Basics
Like equity ETFs, fixed-income ETFs offer exposure to a basket of securities that, in this case, is a basket of bonds. Fixed-income ETFs target all corners of the market, from speculative emerging market debt to top-notch U.S. government debt.
The process for picking a fixed-income ETF is similar to picking any other asset class. First, you’ll need to determine your targeted exposure—the type of bonds you’re interested in. Next, you’ll need to consider the credit ratings and interest-rate risk of the ETF’s underlying securities.
Broadly speaking, fixed-income ETFs fall into four categories:
- Sovereign – ETFs targeting fixed-income security issues by governments of sovereign nations; U.S. Treasurys and U.K. gilts fall into this category
- Corporate – ETFs targeting fixed-income securities issued by corporations
- Municipals – ETFs targeting fixed-income securities issued by U.S. municipalities
- Broad Market – ETFs that have exposure to both sovereign and corporate debt
You’ll also need to choose the geographic exposure you want. Do you want to target U.S.-issued securities? Or fixed-income securities issued in the U.K. or the eurozone? Or do you want to venture out into the emerging market space? Conventional wisdom suggests there are growth opportunities in less-developed markets, but not without additional risks.
It’s also important to understand how the index a fixed-income ETF tracks selects and weights its holdings. While most fixed-income indexes tracked by ETFs are selected and weighted based on market value—total outstanding debt issuance—some are selected based on credit ratings, liquidity or currency denomination.
For those looking at the active space, PIMCO offers a handful of actively managed fixed-income products as well. Active managers need to be evaluated for their track record and likelihood of outperformance, so extra due diligence is required there.
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