Content provided by Marc Pfeffer, CLS Senior Portfolio Manager
One of the newest trends in the densely populated world of ETFs now includes fixed income. As investors turn to the safety of bonds in anticipation of higher interest rates, fund companies are launching new, and increasingly complex, fixed income ETFs. But as I recently told Barron’s, investors should be aware that bond ETFs, on average, have higher trading costs than typical stock ETFs, and some of the newer bond ETFs have remarkably high bid-ask spreads. Those costs add up and could make a significant dent in returns.
Bond ETFs are growing enormously – investors allocated $12 billion to the sector just last month – and 138 new bond ETFs have launched since 2012, according to Morningstar. However, despite this growth, investors still have far more plentiful options in the stock ETF market. The average stock ETF spread is only a few points lower than bonds, but investors can find stock options with spreads as low as a penny. As I told Barron’s, in this low-interest-rate environment most investors are lucky to have a positive rate of return at all. So when you factor in high bid-ask spreads, the performance they think they had evaporates.
But fixed income ETFs have support from respected money managers. Barron’s recently published a discussion with top investment officers, who said they expect low, but positive, returns in fixed income and see opportunity in high-yield municipal bonds that have been underpriced. These experts made a few recommendations, including iShares Short-Term National AMT-Free Muni Bond [SUB] and lower-quality municipal bonds, such as Market Vectors High-Yield Municipal Index ETF [HYD].
While I agree with many of the points made, I would suggest a couple of alternatives. SPDR Nuveen Barclays Short Term Municipal Bond ETF [SHM] could provide better liquidity than SUB, and while HYD has performed well, I would prefer to stay with a higher-quality option, such as iShares National AMT-Free Muni Bond [MUB]. Bonds with maturity dates can adversely impact performance and incur expensive trading costs as they convert to cash; and larger, more liquid funds can offset some of the higher trading costs involved in bond ETFs.
When interest rates are this low, I believe any extra cost that cuts into returns is too high. Like we say at CLS, every basis point matters!
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An ETF is a type of investment company whose investment objective is to achieve the same return as a particular index, sector, or basket. To achieve this, an ETF will primarily invest in all of the securities, or a representative sample of the securities, that are included in the selected index, sector, or basket. ETFs are subject to the same risks as an individual stock, as well as additional risks based on the sector the ETF invests in. Fixed Income is an investment style designed to return income on a periodic basis. Generally, fixed income strategies invest in bonds, real estate, loans, and other types of debt instruments. Diversifiable risks associated with fixed income investing include, but are not limited to, opportunity risk, credit risk, reinvestment risk, and call risk.