Bond ETFs Grow More Specialized

NEW YORK (TheStreet) -- Most ETF investors know that the first equity fund was the S&P 500 SPDR ( SPY), which of course tracks a very broad index. Subsequent equity funds then got narrower to cover sectors, foreign countries, themes and possibly the ridiculous; there was a short-lived ophthalmology ETF from the now defunct Health Shares.

Bond ETFs are following a similar trajectory. The earlier funds have been generic, covering the U.S. Treasury market like the iShares Barclays 20+ year Treasury Bond Fund ( TLT); very broad covering the entire market like the iShares Barclays Aggregate Bond Fund ( AGG); or broadly covering the corporate bond market like the iShares iBoxx $ Investment Grade Corporate Bond Fund ( LQD).

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In the last couple of years bond ETFs have become more specialized, with foreign funds having proliferated. The next phase of specialization is rolling out with sector bond funds. PowerShares filed for a suite of sector bond funds several years ago but did not end up bringing them to the market but now iShares has.

The iShares Financial Sector Bond Fund ( MONY) targets ground zero of the financial crisis with large positions in Citigroup ( C), Bank of America ( BAC) and JP Morgan ( JPM). Traditional investment banks like Morgan Stanley ( MS) and Goldman Sachs ( GS) are also in the fund.

MONY's average credit rating is BBB+, the effective duration is 5.32 years and the SEC yield is reported at 3.0%. With that five-year duration, the fund does not take undue interest-rate risk should rates go up, but obviously the big risk here is credit risk.

If the financial crisis from 2008 really was the worst in 80 years then it is plausible that more shoes could drop for banks and other financial institutions. Conditions in Europe are continuing to deteriorate and to the extent U.S. banks are exposed, or believed to be exposed, there could be more trouble ahead. Would they be bailed out again? If you believe they would not get another bailout then this fund becomes relatively unattractive.

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iShares has also come out with the Utilities Sector Bond Fund ( AMPS) which should take far less credit risk than MONY, but with an effective duration of 8.23 years it will take more interest-rate risk. The SEC yield for AMPS is reported at 3.16%, which seems a little low when compared to the much shorter duration for MONY.

The most interesting of the three sector ETFs is the iShares Industrial Sector Bond Fund ( ENGN). Its duration is 7.08 years and shows an SEC yield of 2.87%. The average credit rating is BBB+. Despite the theme of the fund of being industrial, it is more of an ex-financials corporate bond fund with companies like AT&T ( T), Pepsico ( PEP) and Oracle ( ORCL) alongside names like Caterpillar ( CAT) and Dow Chemical ( DOW).

If rates do rise, these funds should not drop in price anywhere near as much as TLT, but they will look very volatile when compared to a very short maturity fund like iShares Barclays 1-3 Year Treasury Bond Fund ( SHY).

As these are new funds, investors should prepare for the possibility that dividend payments will be uneven as there will likely be a swift increase in assets under management. The significance here is that today a fund may collect interest on $1 million face value of a bond, but a week from now it might have to pay out that interest to twice the number of shares, making the actual payout look unattractive.

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As with foreign bond ETFs, hopefully sector fund become a popular option leading to more choices. Too many funds are very heavy in bonds from financial companies and any exposure available for people who would rather not buy individual bond issues would be welcome, as an excellent way to reduce credit risk.