Bond ETFs: Popular But Risky


Exchange-traded funds investing in bonds are investors’ latest darlings, drawing in more money this year than any other class of ETFs, according to fund-tracking firm Morningstar Inc. (Stock Quote: MORN)

But are investors taking on more risk than they think?

Certainly, many investors must be moving into bond ETFs for good reason, as ETFs offer easy diversification and rock-bottom fees. It’s especially important to minimize fees when bond yields are as low as they are now.

It’s a safe bet, however, that many investors are piling into bond ETFs for the wrong reasons: because some have done well over the past year or two, or out of a belief that bonds are safer than they really are.

ETFs are investment pools similar to mutual funds, but they are traded like stocks, allowing investors to buy anytime during the trading day as prices fluctuate, rather than at the single end-of-day price charged by mutual funds. Most ETFs are index-style investments that track standard market gauges. In addition to low fees, they tend to be “tax efficient,” meaning investors incur minimal annual tax bills.

Morningstar says investors have poured about $32.1 billion into taxable-bond ETFs this year through November, while taking about $32.6 billion out of ETFs that invest in U.S. stocks. Another $3.2 billion has flowed into ETFs holding tax-exempt municipal bonds.

The numbers are remarkable given that bond ETFs are relative newcomers. There are just 61 taxable-bond ETFs compared to 447 U.S. Stock ETFs.

Chances are that many investors are drawn to bond ETFs by appealing performance figures, which means emphasizing what an investment did in the past rather than the more important issue of how it’s likely to do in the future.

Vanguard Total Bond Market ETF (Stock Quote: BND) has been one of the most appealing bond ETFs for investors this year, Morningstar says. It returned nearly 7% in 2008, while the biggest stock market ETF, SPDRS (Stock Quote: SPY) lost nearly 37%.

Things have changed this year, with the bond fund up just 4.3% versus 26% for the stock fund. But many investors who were badly stung by stocks in 2008 are apparently clinging to the idea that bonds are safer.

Bonds have indeed been safer, and in many cases more profitable, in recent years. But what about going forward?

The lion’s share of bonds’ recent gains were produced by price increases caused by falling interest rates. If a new bond yields 3%, investors will pay more for an older one yielding 5%.

But yields are now so low that they’re more likely to go up than down. That would drive down prices of today’s low-rate bonds.

Fortunately, Morningstar suggests that quite a few investors understand this “interest-rate risk” and are emphasizing ETFs containing bonds with short maturities. A bond that matures in one year is hurt less by interest increases than one maturing in 10 years, because its owner won’t have to live with the below-market yield for long.

Among the most popular of such ETFs, according to Morningstar: Vanguard Short-Term Bond ETF (Stock Quote: BSV), iShares Barclays 1-3 Year Credit Bond (Stock Quote: CSJ) and PIMCO 1-3 Year U.S. Treasury Index (Stock Quote: TUZ).

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