This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by Mike Venuto, co-founder and chief investment officer of New York-based Toroso Investments.
Many investors expect the return streams from bond ETFs to behave like the direct purchase of a bond, essentially providing current income with the likely return of principal at a future date. Although the expansion of ETFs has provided investors access to bonds, and at a reasonable cost, the performance behavior of these ETFs are often very different from the direct purchase of individual bonds.
The top five bond ETFs by assets include:
- Vanguard Total Bond Market ETF (BND |B-94)
- iShares Core U.S. Aggregate Bond ETF (AGG | A-98)
- iShares Global High Yield Corporate Bond ETF (HYG | B-64)
- iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD | A-77)
- Vanguard Short-Term Bond ETF (BSV | B-69)
These ETFs represent about $90 billion in assets and have an average current yield of 3.07 percent and an average duration of 5.05 years. So, like a direct purchase in a bond, investors can expect that a 100 bps rise in interest rates would cause a 5 percent reduction in principal, wiping out more than a year and a half of the average income.
The major difference between the ETF structure and the direct purchase is that the ETF investor may never recover the 5 percent principal at maturity because the index does not mature.
The lineup of BulletShares target-date maturity bond ETFs from Guggenheim has tried to provide a solution to this conundrum, but they are still subject to the second inefficiency: The future income distribution of the ETF is not locked in at purchase at the current yield; it will change as the constituents of the index change.
Toroso’s conclusion is that some of the traditional metrics of evaluating bonds, like current yield and average maturity, are inadequate relative to the ETF structure.
That said, we have devised a methodology for income ETF security selection that is more consistent with the behavior of bond ETFs. Additionally, Toroso uses an asset allocation methodology for bond ETFs that behaves more like a direct purchase of a bond.
With the threat of rising interest rates looming, how can investors evaluate the risk associated with bond ETFs if metrics like maturity and coupon do not apply to the ETF structure? I believe this all boils down to maximizing income, with the minimal amount of volatility possible.
To assist in this, we use a methodology we call the risk-adjusted excess income ratio (RAEI). We take the principles of the Sharpe ratio, and seek out excess output above a risk-free rate per unit of volatility but, instead of return, we focus on income. The formula is below:
Risk Adjusted Excess Income Ratio = (Yield - Risk-Free Yield) / 3-Year Standard Deviation
The formula allows us to evaluate the excess yield per unit of volatility. Positive ratio outputs, relative to similar investments, are indicative of an attractive investment. This, combined with other efficient metrics, like duration, assist us in choosing optimal bond ETFs.
For the purpose of this article, we analyzed the five largest bond ETFs, as well as two securities used within Toroso’s strategies, and used the 12-month yield of the iShares 1-3 Year Treasury Bond ETF (SHY | A-97) as our risk-free yield (0.37 percent).