ETF Education: August 2019

August 01, 2019

ETF UNIVERSITY

Fixed Income ETFs: An Overview

Fixed income securities come in many shapes and sizes, but whether they are bonds or another type of fixed income security, they are all at their core simply 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% 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?

The Truth About Coupons
In fact, the value of the bond changes over time. Imagine that a hypothetical bond’s 5% 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% the year after the bond is issued, the same company might issue nearly identical bonds with a 7% coupon. Suddenly, last year’s bonds with their 5% coupons don’t look very attractive to investors. Since the coupon is fixed at 5%, 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. While the coupon of the bond is fixed, the bond’s value 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% coupon at the time it was issued was also 5%. 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% 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.

Exposure 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

Choosing A Bond ETF
When selecting a fixed income ETF, you’ll need to consider things like credit ratings and interest rates risk, just like you would with an individual bond. Then you’ll need to decide what type of bond category exposure you want and choose the geographic exposure you want, whether it be domestic, eurozone, U.K., Asian or emerging market bonds or some other geography.

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.

If you’re looking at the active space, managers need to be evaluated for their track record and likelihood of outperformance, so extra due diligence is required there.

 


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