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McCall’s Call: A Closer Look At Bonds

Indeed, as attention turned to the specifics of the debt agreement and, more to the point, the slowing pace of economic growth around the world, investors began selling equities big time this week, which has put bonds in favor.

The Vanguard Total Bond Market ETF (NYSEArca:BND), a proxy for the whole bond market, is up 3.4 percent in 2011 at about the same time that all of the S&P 500’s gains for the year have been lost. Selling turned downright scary on Thursday, Aug. 4 when the S&P 500 nose-dived 60.27 points, or 4.8 percent, to 1,200.07.

The problem with BND is that it yields just over 2.5 percent, which means many pockets of the bond market have more attractive yields without too much extra risk. The good news is that ETFs are on the market that canvass each area, including funds targeting high-yield markets for both taxable and tax-free accounts.

But one part of the bond market I’ll avoid like the plague for a while is U.S. Treasurys. So, before I talk about the areas of the bond market where I am putting my clients’ assets, let me explain my position on Treasurys.

Why I Hate Treasurys

The No. 1 reason I’ll completely avoid or, at a minimum, be extremely underweight, U.S. Treasurys is that I think interest rates simply have to go up in the coming years. Even if the U.S. continues with growth below 2 percent, the government can’t keep interest rates artificially low indefinitely.

Also, now that the Fed’s attempt to keep interest rates low using quantitative easing appears to be over, the market is likely to gain the upper hand over time in dictating rates.

The other reason I’m holding Treasurys at arm’s length is the credit quality of the U.S. government. As investors -- especially China -- begin to question the underlying foundations of the U.S. economy, they may demand higher interest rates to loan the U.S. the money it needs to continue operating.

That said, if an investor held a gun to my head and demanded I pick a Treasurys ETF to buy today, I would insist on investing in short-maturity bills or notes. If and when interest rates increase, prices of short-term bond ETFs will take less of a hit.

The downside is that investors receive a smaller monthly dividend payment for that lowered risk when interest rates increase.

The iShares Barclays 1-3 Year Treasury Bond ETF (NYSEArca:SHY) is up 0.6 percent in 2011 and pays a minimal SEC 30-day yield of 0.about 25 percent. But, it’s stable, and comes with an annual expense ratio of 0.15 percent.

Investing in Fixed Income

With U.S. government bond ETFs pretty much off my radar, as I said there are plenty of other options in the world of fixed income where I’m willing to invest.

Right now, my largest fixed-income holdings for clients are the:

  • SPDR Barclays High Yield Bond ETF (NYSEArca:JNK)
  • PowerShares Emerging Markets Sovereign Debt ETF (NYSEArca:PCY)
  • iShares iBoxx Corporate Bond ETF (NYSEArca:LQD)
  • Market Vectors High Yield Municipal Bond ETF (NYSEArca:HYD)

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Together, the four constitute a diverse mix of junk bonds, investment-grade bonds, municipal bonds, and foreign bonds. I’ve owned most of the positions on behalf of clients for well over a year, and all are generating positive returns with varying yields.

The one ETF on my preferred that most experts would shy away from is my favorite for the right circumstance – HYD.

The ETF is composed of 25 percent investment-grade municipal bonds and 75 percent that are either junk status or not rated. This allows the ETF to offer a tax-free yield of about 6.0 percent, equivalent to a yield of 9.27 percent in a taxable account if the investor falls into the 35 percent tax bracket.

The catch is that HYD is only for use in taxable accounts, and it’s only for investors willing to take a little extra risk for an above-average yield. Its net expense ratio is 0.35 percent.

In taxable accounts, JNK is a high reward-to-risk play at the current price. The chances of the companies in this ETF defaulting on their debt is extremely low and therefore the yields should remain high as the ETF vacillates within a 10 percent trading range.

JNK currently offers a 30-day SEC yield of 6.8 percent and has a 0.40 percent expense ratio.

I also like to invest in debt issued by foreign countries such as PCY. I talked about this in a column last week, so I won’t go overboard, except to say the dollar-denominated ETF has a 30-day SEC yield of 5.13 percent. The bottom line is that there are attractive yields in emerging markets debt without too much extra risk.

Fixed Income for Everyone

In the end, the traditional thinking that fixed income is only for the elderly, wealthy, or ultra-conservative is out of date.

I have even my most aggressive clients in a couple of fixed-income ETFs to diversify and provided above-average monthly income. The strategy has worked the past few years with JNK being a big winner, up over 50 percent since our purchase.

The bottom line here is that it’s time to think outside the box when it comes to fixed income and to stay away from the U.S. government debt for a year or two.

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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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