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An ETF Bonding Experience

Eight new iShares ETFs fill in some gaps in the fixed-income segment.

If you follow the ETF market at all, you already know that iShares and Lehman Brothers launched eight new fixed-income ETFs last week. They are:

Short Treasury Bond Fund

3-7 Year Treasury Bond Fund

10-20 Year Treasury Bond Fund

1-3 Year Credit Bond Fund

Intermediate Credit Bond Fund

Credit Bond Fund

Intermediate Government/Credit Bond Fund

Government/Credit Bond Fund

The funds with the word "Treasury" in their titles invest solely in Treasuries, the funds with the word "credit" are corporate bonds, and the funds with the words "government" and "credit" are a blend of Treasuries and corporates.

These funds will help investors in some aspects but come up short in others.

The bond ETFs that already existed were not a complete set, and where the treasury ETFs are concerned, SHV, IEI and TLH clearly fill the gaps. They give investors more specific control and management over their average maturity, plus the chance to reallocate in anticipation of interest rate changes, which, if done correctly, could serve to reduce bond portfolio volatility.

These funds could also be a handy tool for institutional investors looking to speculate on various spreads across the yield curve getting narrower or wider. Combinations of two or more ETFs in various long/short permutations allow for some very sophisticated uses. The corporate and corporate/govie funds allow for more of the same between different fixed-income products, which creates an obvious path to foreign-bond ETFs, along with other segments within the bond market.

There are some things that bond ETFs cannot do. According to data from iShares, the yield to maturity for the 10- to 20-year Treasury fund was 4.87% on Dec. 31, 2006. If you thought that for the next 10 years 4.87% was as good as it will get for that time frame and you bought TLH in that belief, you would not be locking in 4.87%. The fund will always have a 10- to 20-year time horizon. If five years from now the 10- and 20-year Treasuries are yielding 2%, so will TLH. It will not be yielding today's 4.87%. You will not have locked in anything.

Another point along these lines is that dividends paid by fixed-income ETFs vary with almost every payment because interest rates are always changing. This is important because it creates an element of unpredictability in the fixed-income ETFs.

If reversion to the mean has any meaning at all, it makes sense to think that long-dated bonds will yield somewhere in the 6%-7% range at some point in the future (these numbers are not high by historical standards). I personally would want to lock in 7% for 10 years if I could, and TLH will not do that.

So at this point, the issue becomes finding the best tool for your portfolio. A $1 million bond portfolio is probably better off with more individual bonds, especially the portion devoted to Treasury or agency bonds. A $25,000 bond portfolio should probably tilt to investment products, including ETFs.

Foreign Bond Introduction?

I would note that the biggest development with the announcement of these ETFs might have come in

Gregg Greenberg's interview with iShares head of U.S. product development Noel Archard, in which it was disclosed that foreign-bond ETFs are on their radar.

Foreign-bond indices have already been created by MSCI Barra for the sovereign debt of 24 countries, as well as four regional indices. I don't know whether iShares would use any of these indices or not, but that they exist makes creating ETFs a little easier.

The reason I am so interested in the potential for foreign-bond ETFs is that even for $1 million bond portfolios, accessing foreign bonds is very difficult to do. While there are plenty of traditional mutual funds that own foreign bonds, they tend to be actively managed, and I prefer the chance to select countries and regions on my own and weight them as I see fit. The foreign-bond ETFs will have the same flaws, but they could be the best tool nonetheless.

At the time of publication, Nusbaum held no positions in the stocks mentioned, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;

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