Bond etfs are becoming more popular with investors.They provide a cheap way to invest in a basket of bonds that trade in the secondary market like stocks and can be accessed through most brokerage platforms.But as interest rates rise, are these instruments safe for investors?
What many investors may not realize is that owning a bond ETF is not the same as owning the underlying bond.This becomes particularly important in the rate of rise environment.So what options do investors have when they want cheap and easy exposure to bonds?
Fixed-income etfs offer investors multiple advantages, such as diversification, liquidity and access to specific segments of the bond market — whether domestic or international, investment grade or high yield.They are also easy to trade, allowing investors to earn a fixed return on the minimum investment.
However, this ease of use has now led investors to confuse fixed income exposure with real fixed income exposure. The equity-like nature of bond etfs means that coupon payments translate into periodic dividend payments that are not necessarily predictable.This and the continued sensitivity of bond etfs to interest rates are important factors to consider, especially when rates rise.
Investors can use a strategy known as a ‘bond ladder’ to hobble purchases of bonds by buying multiple tranches with different maturities, When the first tranche matures, the proceeds will be reinvested in bonds with maturities matching the longest tranche on the original ladder. This strategy helps reduce interest rate risk by reinvesting maturing earnings at potentially higher interest rates.It also allows a reassessment of credit risk in individual portfolios.
But this strategy requires buying individual bonds with specific maturities.It may not be easy for individual investors to seek fixed-income exposure to parts of their portfolios and limited assets, or to find professional fund managers.
Several fund managers have launched term ETFs, in which the funds hold bonds that mature in the same year.As a result, the fund’s maturity yield matches the yield of the underlying bond, making monthly income distribution more predictable.
Unlike bond etfs, underlying bonds are not reinvested throughout the fund’s life cycle to maintain their duration.Instead, the term ETF manager allows bonds to mature and investors to recoup their principal in cash at the final maturity date of the issue.
This makes it easy for investors to use term etfs to create bond echelons without worrying about principal losses if they hold the funds until maturity.
Franklin Templeton Investments: in 2018, rising inflation, rising U.S. interest rates and rising trade tensions raised concerns about global economic growth and stock market volatility.
In fixed income, we are more focused on the shorter end of the yield curve and generally have a positive bias towards corporate credit because we still think fundamentals are very favourable.
Two-year Treasury yields rose from 1.89 per cent to 2.52 per cent in the first half of 2018.Moreover, while the spread between highly rated bonds and us treasuries has widened, the spread between high-yield bonds and treasuries has narrowed this year.
In some of our income-oriented portfolios, we have taken positions in 1-5 year Treasury bills given the recent rise in yields in some of our high-yield corporate bonds and equities, which appear to have met our full valuation expectations.Importantly, we believe this will provide flexibility during potential volatility in the second half of 2018.
All investments involve risks, including possible principal losses.The fund’s share price and earnings are affected by interest rate changes.Bond prices usually move in opposition to interest rates.As a result, when the price of bonds in a fund changes with interest rates, the fund’s share price may fall.Changes in the issuer’s financial strength or credit rating may affect its value.The fund’s portfolio includes a significant portion of high-yield, low-rated corporate bonds because of their relatively high yields.Floating rate loan is a tool with low rating and high yield, and the default risk increases, which may lead to principal loss.These securities carry more credit risk than investment-grade securities.Stock prices sometimes fluctuate rapidly and violently due to factors affecting individual companies, specific industries or sectors, or general market conditions.