Some investors who sought capital preservation last year in bond-holding exchange-traded funds (ETFs) got their reward. But others received a knock on the head. Those willing to take riskier bets did best. The deciding factor, say analysts, owes to differences in the underlying bonds themselves. Fear of rising interest rates sent investors running from long-term commitments, like long-term bonds, whose yields may prove paltry when rates rise. And the prospects of not garnering enough return, coupled with improving credit risk among corporate bonds, lured some investors to higher-risk securities. Flexibility has been key. Unlike individual bonds or mutual funds, ETFs make it easier for investors to shift securities in conjunction with these dynamics. Investors took advantage of that agility by moving out of long-term bond funds as 2013 drew to a close. For the moment, analysts expect investors in 2014 to keep betting on shorter-term investments.
Investors largely bought long-term bonds in order to protect their cash. Yet out of the 191 fixed-income ETFs followed by S&P Capital IQ analysts, 109 of the bonds either failed to preserve or lost some investor capital. The biggest loser among them was Pimcos 25+ Year Zero Coupon U.S. Treasury Index ETF (ZROZ). Despite the fact that the funds were based on safe government bonds, ZROZ fell 21 percent. And Vanguards Extended Duration Treasury ETF (EDV) was right behind it, with a loss of 20 percent, according to Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ in New York.
These declines marked a clear shift in the funds performance, compared with 2011, when ZROZ and EDV rose 60 percent and 56 percent, respectively. The funds gained slightly less than 10 percent in 2012. Thus ETFs such as IShares Floating Rate Bond, the IShares Short Maturity Bond and Vanguards Short-Term Corporate Bond are likely choices in 2014, says Rosenbluth, as well as higher-yield holdings such as the Guggenheim BulletShares 2018 High-Yield Corporate Bond.
Rosenbluth calls ZROZ the worst of the bunch. In his January 2 Trends & Ideas report, Rosenbluth wrote, Its sky-high duration of 27 years is a concern to us. The Federal Reserves fourth-quarter 2013 announcement that it would begin to taper its bond-buying program might not appear to investors to be a big deal, he says. But that is $10 billion less the Fed is buying every month. Part of the resulting rush out of long-term-duration bonds was motivated by pent-up fear of a larger taper and the recognition that the Feds support was eventually going to end.
At some point, it was not if but when, says Rosenbluth. What investors were predicting had become reality, so they largely got out of long-term bonds. Going forward, he says, a lot of money will be moving out of longer-term ETFs. For how long and just how much will depend on actions by the Fed and economic events. Bond yields have come in a little to start the year based on the belief that the timing of Fed tapering efforts may be extended and amid weaker jobs numbers, he says.
Although it is difficult to forecast bond flows and their timing, the absence of Fed bond buying is widely expected to result in rising interest rates, which usually favor shorter bonds.
But Quincy Krosby, chief market strategist for Prudential Annuities in Shelton, Connecticut, recently discounted tapering fears during the insurance and investment companys annual financial forecast on January 7, when she expressed optimism for a normalization of interest rates. Most people fail to consider, she says, that Janet Yellen, Ben Bernankes successor as chair of the Fed, has been No. 2 for some time and favors transparency in offering forward guidance. Therefore, Krosby doesnt expect any abrupt change of direction or any recklessness. She was the one who worried about the subprime effect on the markets, notes Krosby.
Winners last year were 51 fixed-income ETFs followed by S&P Capital IQ. Among them is the IShares Global ex USD High Yield Corporate Bond ETF (HYXU 58 market weight), which delivered to investors a welcome 13 percent rise. The fund typifies last years risk-reward scenario seen often in the markets, and its four-year, short-duration holdings are reflective of the past years success with this investment style, says Rosenbluth. The HYXU yield of 4 percent also signifies the markets increasing appetite for risk, which Rosenbluth attributes to the improving global macroeconomy, strong corporate earnings and a low default rate (see also Global Macro Outlook for 2014 Is Sunny, with Risks on the Horizon).
Another winner was the AdvisorShares Peritus High Yield ETF (HYLD 52 market weight), with an 11 percent increase. Both HYLD and Guggenheim BulletShares 2018 High Yield Corporate Bond ETF (BSJI 27 market weight), with an 8 percent return, are holding average-duration bonds of roughly four years and under. HYLD consists mostly of B-grade issues, and BSJI has a combination of single- and double-B grades.
HYLD is interesting in that it is an actively managed bond ETF, which perhaps gives it an edge in bond selection. The fund has fluctuated from year to year, however, and its net expense ratio of 1.25 percent is high, especially when compared with HYXUs 0.40 percent ratio.
An alternative to the HYLD fund that offers lower-risk triple-A as well as triple-B bonds is the actively managed IShares Short Maturity Bond ETF (NEAR). At 0.25 percent, the expense ratio is much lower. But having only launched on September 25, the fund does not yet have performance numbers.
Lipper Service, a Thomson Reuters company, also tracked inflows to short-duration products in 2013. Both the Lipper Ultra-Short Obligations ETF category and the Lipper Short Investment-Grade Debt ETF categories witnessed record increased inflows of $1.9 billion and $12.1 billion, respectively, notes Barry Fennell, senior research analyst for Lipper in Boston. In 2014 Fennell expects flows from ETFs to the short end of the curve to stay positive but retain the volatility seen toward the end of 2013 and in the first week of 2014. He sees investors awaiting more clarity around the Federal Reserves near- to intermediate-term plans for its bond-purchasing program.