Low-cost, income-oriented exchange based products may be the real story in next-gen ETFs

December 2, 2011 — 7:44 AM UTC by Guest Columnist Chris Greene


Scouring the fixed-Income ETF landscape for yield away from the mainstream headlines regarding the various leveraged offerings available, there are some interesting new products that have come to market. The quiet trend of low-cost, transparent, income-oriented exchange based products continues and is what we think is the real story in next-gen ETFs. We should continue to see ETFs increase their role in professionally managed portfolios. We offer some specific thoughts on a few below. First, a listing of some of the more interesting new products.

Short-Term 0-5 Year High-Yield Bond (HYS) — launched in June
Australia Country Bond (AUD) — launched in October
Canada Country Bond (CAD) — launched in November
Germany Country Bond (BUND) — launched in November

U.S. Bank Loan Bond Index (BKLN) — launched in March

U.S. Industrials Sector Bond — in registration
U.S. Financial Sector Bond — in registration
U.S. Utilities Sector Bond — in registration
S&P International Preferred Stock (IPFF) — launched in November

Emerging Market Bonds (ELD) — Launched in 2010

These types of ETFs enable investors to efficiently access areas of value in the market and bias portfolios without the execution/liquidity issues (and risks) of individual securities. Importantly, with this added flexibility comes a need to thoughtfully measure expected return and risk in these products. We believe in using both absolute and relative measures to understand segment performance and the risk of drawdowns.

Below is a high-level sample view of the U.S. fixed-income ETF marketplace:

Of the new issues listed above, we highlight two to keep on the radar given their return characteristics and overall profile (yield, duration, currency, etc)

1. Pimco Short-Term High-Yield (HYS) — Historically, high-yield bonds correlate with equities more than bonds. We highlight this ETF because it holds lower-duration high-yield bonds than the typical high-yield bond indexes, making it more like a low-beta equity fund with a high coupon to earn while you wait. HYS could either replace some of the equity allocation (reduce risk) in more conservative accounts — or it could enhance return in more aggressive accounts as a bond overweight. The yield to maturity is near 7% and overall volatility of HYS is contained recently at about 7%. While junk-bonds are subject to sudden volatility due to illiquidity issues in the underlying securities, this is mitigated a bit by the lower duration of this particular fund versus typical high-yield-bond funds. We would note that even the most defensive equities, such as the Consumer Staples ETFs, have seen recent volatility more than twice that of HYS.

2. PowerShares Bank Loan (BKLN) — The bank loan market is another non-core bond area with hybrid characteristics, strong yield and far less volatility than equities. Since its launch in March, BKLN has acted a lot like a muted version of some of the high-dividend equity ETFs. Similar to any short-term duration fund, bank loans reset their rates quickly to the environment. However, because lower-tier credits often trade differently than typical bonds, the near-zero interest rate environment in Treasuries does not mean near-zero for bank loans. While there is credit risk just like with HYS, you are paid a 7%+ yield relative to sub-2% on short-term high-grade paper. Relative to the safest bonds — which yield essentially nothing — BKLN is obviously riskier. But relative to equities, drawdowns should be less.

The U.S. dollar — mostly by default —- has been something of a safe haven, and this is likely going to continue until the episode in Europe matures to the point of some clarity on a solution. This is part of the thesis for U.S. high-yield, as opposed to reaching for international yield.

The lower-duration aspect to the high-yield arena is a new development in ETFs. For very low cost you have an institution like Pimco effectively rolling the proceeds of maturing high-yield bonds on your behalf yet without the extra restrictions and fees in mutual funds. You also get pure index exposure rather than a more complicated, less-transparent fund.

Another relatively new fund is WisdomTree Emerging Market Bond (ELD). With a YTM of 5.4% and a duration of about 5 years, this fund can provide access in a hard-to-reach area of the bond market (emerging market fixed-income). Its country allocation is well-diversified with 10.6% in Brazil being the top holding. Because it is denominated in various foreign currencies, there is a bit of an extra risk with regard to fallout to non-safe-haven currencies, especially given the current environment.

Longer-term, the iShares S&P International Preferred Stock ETF (IPFF) may be somewhat interesting. It is currently positioned as essentially a Canadian-financials preferred ETF (73.4% of the fund is in Canada and about 85% of the fund is in financial preferreds). Exposure to Europe is minor, 11% in the UK and 5% in Sweden (note that neither uses the euro as its currency). While individual preferred securities are a very viable option as well (i.e., better yields), from a diversification and liquidity standpoint, you may be more comfortable accepting a lower total return to get any international preferreds exposure in ETF form. IPFF is a brand-new product, and we would like to see the dividend pattern develop.

Lastly, we just wanted to note some interesting new filings by iShares:

iShares Industrials Sector Bond ETF
iShares Financials Sector Bond ETF
iShares Utilities Sector Bond ETF

These investment-grade products, though still in registration, provide a preview for the continued development in the world of fixed-income ETFs. While the details of these are pending SEC review, clearly something like a utilities sector bond ETF would possess some different characteristics than a financials sector ETF, again offering opportunities for advisers to find low-cost exposure to different bond segments with the inherent flexibility of an exchange-based index product.

Chris Greene, a chartered financial analyst, has a diverse financial background spanning more than 19 years. He began his career in investment banking at Hambrecht & Quist in San Francisco. He was an institutional portfolio manager for Wells Capital Management and a portfolio manager for BCI Capital Management. Chris co-founded ETFreplay.com, Inc. in 2009. The primary reason people subscribe to the site is that they can back-test various ETF scenarios and strategies easily. Historically, this could be done with investment software but it required using proprietary code.

Mentioned in this article:

ETFreplay.com, Inc.
Consulting Firm
Top Executive: F. Chris Greene, CFA

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