Asset Managers' Top Fixed-Income ETF Picks For 2013

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2013: A Look Back And Ahead

With risk-free Treasury bonds yielding less than 2%, thanks to the Federal Reserve's easy-money policies, where can ETF investors get the most income for little risk? Our panel of asset managers share their best fixed-income ETF investing ideas for 2013.

• Alan Zafran, partner at Luminous Capital in Portola Valley, Calif., with $5.7 billion in assets under management:iShares iBoxx Investment Grade Corporate Bond ( LQD ) and SPDR S&P 500 ETF Trust ( SPY ).

Unfortunately, it is very difficult to predict the economic consequences that will result from the inflation-inducing action steps taken by politicians, central bankers and business leaders who are fighting deflationary pressures. A balance of LQD and SPY, in proportion to one's investment goals and risk tolerance, seems very well-suited for today's investment climate.

Market consensus seems to be that some sort of grand bargain will be fashioned in 2013. Moreover, "financial repression" has pushed down the yields of 10-year Treasuries, investment-grade municipals, investment-grade corporates and high-yield bonds.

With the S&P 500 trading at 14.4 times earnings, each dollar invested in America's 500 largest companies yields 6.94 cents in income. An equity investor is earning about 5.15% more per year in yield than by buying a "risk-free" 10-year U.S. Treasury bond. This equity-risk premium is near its 40-year high mark.

So the bulls can make a strong case that stocks will rise because: 1. the equity-risk premium remains very wide by historical standards; 2. price-to-earnings ratios are below 40-year historical averages; 3. corporate earnings will grow next year; 4. corporate balance sheets are strong ; and 5. global central banks remain prepared to intervene on any signs of macro-economic weakness.

Meanwhile, the bears can make an equally strong case that stocks will weaken because: 1. U.S. earnings growth is slowing; 2. corporate margins are at an all-time high and cannot be sustained; 3. the $16.3 trillion U.S. debt problem can only be solved by policies, such as higher taxes and reduced government spending, that hamper future economic growth; 4. Europe has a $3 trillion debt problem and lacks the fiscal apparatus and political willpower to address the problem; and 5. there is no room for an exogenous shock to the global financial system such as Middle East unrest or a major natural catastrophe.

• Mark Eshman, chairman at ClearRock Capital in Ketchum, Idaho, with $370 million in assets under management: iSharesJPMorgan USD Emerging Markets Bond ( EMB ).

Investing in emerging market bonds is a credit improvement story. The average monthly credit rating on the J.P. Morgan Emerging Markets Bond Index Global has improved from B- (non-investment grade or junk) in 1993 to BBB- (credit-quality investment grade) today. Some of this has been due to the fact that EM nations' growth rates have tripled over the last 30 years, while developed nations' growth rates have been flat. And by encouraging domestic demand along with strong exports, the emerging market countries have been able to maintain lower levels of government debt relative to their gross domestic product (35%) than developed nations (111%).

Lower debt ratios decrease the likelihood of default and increase chance of repayment and the issuer's credit quality.

The credit risk for EM debt is overstated. Despite their superior creditworthiness, EM debt yields considerably more than developed-nation debt. Tougher banking regulations, stricter lending requirements, more disciplined central banks, improved corporate and political governance and controlling emerging market inflation, have led to this credit improvement.

The Federal Reserve's quantitative easing policy is having the unintended consequence of dollar devaluation. As the Fed expands our balance sheet, it makes existing dollars worth less. Outside of the European Central Bank, the Bank of Japan and Bank of England, the Fed has expanded its balance sheet more than any country in the world. The EM countries have not done so in to the same degree. This should bolster the value of emerging market currencies for the foreseeable future, making the local currency-denominated EM debt more attractive than its dollar counterpart.

The risk-to-reward trade-off of owning local currency emerging-market debt ETFs is very attractive. Through emerging markets local currency debt ( EMLC ), one gets exposure to local bond markets in emerging economies in local currencies while getting higher yields than generally available from developed market bonds.

Finally, many emerging market countries have already experienced a deleveraging of their economies that the U.S. is still experiencing. Consequently, they have devalued their currencies to historic low levels. So bonds denominated in local currency present two potential sources of return: interest payments and capital gains due to currency appreciation.

The primary risk of investing in EMLC is rising interest rates. The duration in EMLC is 4.95 years, which is relatively low. A 1% rise in rates will knock about 5% off the principal value.

• Anthony Welch, portfolio manager at Sarasota Capital Strategies in Osprey, Fla. , with $40 million in assets under management: Powershares Financial Preferred Portfolio ( PGF ).

With a trailing 12-month yield of 7.2%, this preferred stock portfolio offers an enticing alternative to low-yielding bonds. It is about the same volatility as the S&P 500, but is only 60% correlated to the S&P, providing diversification to an equity portfolio.

Improving underlying fundamentals and improving credit ratings of the issuing firms indicate they have a stronger ability to pay the dividends and ultimately the principal. This creates more demand from investors and often improved price performance, especially if the current yield is based on a lower-than-deserved credit rating.

Preferred financial stocks are not without risk, however. Preferred stocks are usually issued with a call provision that allows the issuer to redeem the securities at par after a period of time, often five years. This means that several of the holdings in PGF could begin to be called from the portfolio starting in 2013 and will most likely be replaced by securities that pay a lower yield.

Rising interest rates and/or a decline in the fundamentals of the underlying issuer could hurt preferreds' prices. According to the fact sheet, PGF has a modified duration of 4.18, which means that a 1% increase in interest rates could cause a 4.18% decline in PGF, all things being equal. I do not expect a rise of that magnitude in 2013, but that is certainly a risk. I would be more concerned with a 2% rise in rate s. If that occurs, PGF would fall in value by more than its dividend, causing a negative total return.

Also, since there is some correlation to the stock market, a general sell-off in the stock market could cause weakness. PGF has had strong support at the 200-day moving average in 2012. I would expect that trend to continue into 2013 and would reconsider holding the fund should it fall 4% to 5% below that line.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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