With Treasuries seemingly priced at bubble proportions, a few other types of bond ETFs figure to provide a smoother ride in a new year.
Last year proved to be a veritable nuclear winter for all investment asset classes except U.S. Treasury Bonds. The ongoing, massive worldwide flight to safety has rendered retired investors bewildered and struggling to find true safety and reasonable rates of return.
Investors are wondering if Treasuries will be king of the hill again in 2009. Not likely, according to Pimco Chief Investment Officer Mohamed El-Erian, who advises against owning those types of bonds since they look very expensive at this point. Andrew Bary punctuated that same sentiment in a recent Barron's piece, exclaiming: "A flight to safety has created a bubble in Treasury Bonds. Get out now!"
So, with Treasuries priced to "bubble" proportions, what asset classes might provide relief to beleaguered investors in search of steady income and safety of capital in 2009?
A growing number of experts suggest the following four asset classes may indeed fill that bill.
- Mortgage-Backed Securities
- Treasury Inflation Protected Securities (TIPS)
- Municipal Bonds
- High-Grade Corporate Bonds
Yields on mortgage-backed securities (MBS) have been declining ever since the Fed's November 2008 announcement that it would purchase up to $500 million of Ginnie Mae, Freddie Mac and Fannie Mae home mortgage-related bonds. But with the first purchases just beginning in January, current yields of this battered asset class still look attractive relative to historical levels. Additionally, with the Fed's intervention, mortgage-backed securities now offer effectively the same Federal guarantee as U.S. Treasuries, but with higher yields. Consider iShares Barclays MBS Bond Fund (NYSE: MBB), iShares Barclays Agency Bond Fund (NYSE: AGZ) and SPDR Barclays Capital Mortgage Backed Bond ETF (NYSE: MBG).
Treasury Inflation Protected Securities (TIPS)
There is little doubt that fears of inflation have recently shifted to forecasts of accelerated economic de-leveraging and to the growing risks of worldwide deflation. This reversal in sentiment has sent TIPS prices plummeting and has driven yields higher. The growing likelihood in the next several years, however, is that burgeoning Federal stimulus programs will lead inflation higher, perhaps to unprecedented levels rivaling the late 1970s, when inflation peaked above 14%. TIPS will thrive as inflation heats up.
Bill Gross, in a January 19, 2009 interview with Barron's, said he expects big payoffs in TIPS within the next six months, as the de-leveraging cycle slows and asset managers are reliquified. He explained that TIPS "can go up 10% to 20% in price, simply on the basis of optimism that deflation has been averted." Take a careful look at iShares Barclays TIPS Bond Fund (NYSE: TIP). Also, consider SPDR Barclays Capital TIPS (NYSE: IPE).
Tax-free municipal bond yields are near historically high levels. Fueled by hedge fund margin calls and unwinding leverage in the highly liquid "tender-option bonds" market, municipal bond prices plummeted to historic lows in November 2008. Although prices have recovered and yields have waned since the bottom, municipals still offer remarkable value compared to U.S. Treasuries.
Even in this current era of growing revenue shortfalls at state and local municipalities, defaults by investment-grade municipals are rare. During the Great Depression, municipal defaults averaged less than 3%.
With today's 3-4% tax free distribution rates, investment-grade municipals look like a bargain (a 4% tax-free yield for a taxpayer in the 35% Federal tax bracket is the taxable equivalent yield of a certificate of deposit or Treasury bond paying 6.2%).
Municipal Bond ETFs worth considering include PowerShares Insured National Municipal Bond Portfolio (NYSE: PZA), iShares S&P National Municipal Bond Index Fund (NYSE: MUB) and SPDR Lehman Municipal Bond ETF (NYSE: TFI).
For Californians who believe Gov. Arnold Schwarzenegger will eventually "terminate" California's rising deficits, the iShares S&P California Municipal Bond Fund (CMF) looks like a good bet. Additionally, Tom Lydon, the Newport Beach, Calif. editor of "ETF Trends," astutely points out that President Obama's administration intends to direct much of its $800 billion stimulus package to infrastructure spending at state and local levels. It makes political sense that California will be high atop the list of states receiving Federal assistance.
For the ultimate in credit safety, look at Market Vector's Pre-Refunded Municipal Index ETF (PRB). PRB is the first ETF investing 100% in "pre-refunded" municipal bonds. Pre-refunded municipals are issued to pay off existing, high-rate bonds. These "pre-res" are fully collateralized by U.S. Treasury securities, making them the only municipal bond class 100% fully guaranteed by the U.S. government.
High-Grade Corporate Bonds
Investment-grade corporate bonds are very cheap at today's prices. According to a recent Morgan Stanley report, current corporate bond prices imply a cumulative 36% default rate in the next five years. This is staggering—more than 7.5 times greater than any previous, actually experienced, five-year default rate. David Swensen, Yale Endowment Fund's chief investment officer, predicts investment-grade corporate bonds will provide patient investors with "equity-like" returns over the next 3 to 5 years.
Additionally, many bond experts agree with Tim Bond's (Barclays Capital's head of Global Asset Allocation) remark to the Financial Times, "Investment-grade Corporate Bond 'spreads' (the difference between Treasury Bond and Corporate Bond yields) are at levels last seen in 1932, which happened to be an excellent point to buy credit—even though it was the middle of the Great Depression."
Yields on investment-grade corporate bonds have been pushed to 5-6% above comparable maturity Treasuries. Portfolio managers are currently snapping up corporate bonds issued by money-center banks, brokers and the largest insurers, as the ongoing government bailout may mitigate some of the risks of corporate defaults.
The only 100% investment-grade corporate bond ETF is iShares iBoxx $ Investment-Grade Corporate Bond Fund (NYSE: LQD). LQD is distributing a robust 5.6%, but this higher yield comes at the cost of high volatility as well. In the three weeks following the September 15, 2008 Lehman Brothers bankruptcy, LQD plunged 25.4%, nearly matching the 32% S&P 500 decline. By January 9, 2009, LQD shot up 35% from its October 10, 2008 low. Recently, LQD has fallen back about 5% from its peak value earlier in January, marking a reasonable entry point for new purchases.
LQD seeks investment results corresponding to the price and yield performance of the iBoxx $ Liquid Investment-Grade Index. This index measures the performance of 100 highly liquid, investment-grade, U.S. dollar-denominated corporate bonds. The average duration of its bonds is 6.25 years, daily trading volume exceeds 800,000 shares and its market cap is $3.7 billion. Despite the low yields and warnings of Pimco and others, if you're willing to blend some Treasuries into your bond portfolio, also look into:
- iShares Barclays Aggregate Bond Index (NYSE: AGG)
- Vanguard Total Bond Market ETF (NYSE: BND)
- SPDR Barclays Aggregate Bond ETF (NYSE: LAG)
Each of these three ETFs attempts to replicate the Barclays Capital U.S. Aggregate Bond Index, which is diversified into three asset classes:
- Treasury and Agency bonds (approximately 37%)
- Mortgage-Backed Securities (38%)
- Investment-Grade Corporate Bonds (25%)
Maturities in this index are relatively short, with 39% of the portfolio maturing in one year or less, and another 34% maturing in less than five years. The average maturity is currently 6.8 years.
The State Street Global Advisor's SPDR Barclays Aggregate Bond ETF (LAG), has a modest $10 million market cap and trades 31,000 shares daily. While Vanguard's Total Bond Market (BND) is a viable contender, AGG is top dog with its $9.7 billion market cap and daily 800,000 shares average trading volume.
2008 performance and yield of the Barclays Aggregate Bond Index and its three index tracking ETFs were excellent. From the Lehman Brothers collapse on September 15, 2008, to the market trough on October 10, 2008, AGG dropped 14.9%, BND lost 14.2% and LAG was down 16.6%. The ensuing recovery into early January was quite dramatic. AGG and BND recovered 21% and 18%, respectively, and LAG bounced back 26%. Through February 6, 2009, AGG, BND and LAG have dropped a modest 3.6%. Current distribution yields are 4.6% for AGG, 4.5% for BND and 3.8% for LAG.
In my next column, we'll consider two additional income-producing asset classes: senior loans and preferred stocks. But for now, your best bets for principal safety and steady income seem to be mortgage-backed securities, Treasury inflation protected securities (TIPS), municipal bonds and high-grade corporate bonds. Sleep well.
Chance Carson is president of Alpine Strategies in Colorado Springs, Colo. He also serves as editor of AboutETFs.com, an educational Web site for retired investors. He welcomes comments and suggestions for future columns at [email protected].