ETF Spotlight: Fixed Income ETFs and Downside Risk Protection

Although we’ve seen some gains in the last few days, it can’t distract us from the fact that the global financial landscape is still rugged, with few signs that we’re on the way toward greener pastures.

As I’ve stressed over the course of the past several months especially, downside protection is the key objective amidst a climate where sudden market drops have become commonplace. Thus, I want to discuss fixed income ETFs, which are a buffer against losses although not against trend reversals leading the markets into bear market territory.

In addition to adhering to a strict sell stop discipline, introducing bond ETF exposure at the very least helps to reduce overall portfolio risk. While we’re not necessarily getting massive returns with most bond ETFs, they are beating most equity ETFs year-to-date, which are drenched in red. Hitting singles and not losing your shirt right now is much better than going for the home run and striking out.

Separating the domestic and international spheres, domestic bond ETFs are the way to go. With European sovereign bonds becoming riskier as contagion spreads and debt levels are highly elevated, we certainly want to avoid Europe. Our most recent bond ETF cutline report is certainly evidence of this.

And while emerging market ETFs have increasingly stronger credit fundamentals, a European crisis of confidence can quickly batter those markets. As we saw with investors flooding to Treasuries last week and earlier this week, the U.S. is still viewed as a safer investment region relatively speaking, and I can’t agree more.

Looking at the maturity spectrum of bond ETFs, longer-term maturity bond ETFs have done especially well. For instance, SPDR Barclays Long Term Treasury ETF (TLO) has YTD performance of 23.1%. Amongst corporate bonds, the SPDR Barclays Capital Long-Term Corporate Bond ETF has returned 7.9% this year. Shorter-term and medium-term bonds have also held their own, with most still in positive territory although additional quantitative easing measures will diminish returns on the short end.

Not to mention, a significant percentage of fixed income ETFs are above their long-term trend lines, especially domestic, long-term government bonds. The iShares Lehman 20+ Treasury Bond ETF (TLT) is almost 14% above its 39-week moving average with YTD performance over 27%. Meanwhile, the Vanguard Long-Term Bond ETF (BLV) is almost 7.5% above its trend line with YTD performance over 15%.

During periods of instability where investors seek lower risk fixed income assets, resulting in lower yields, long-term bond ETFs will perform especially well. For example, a 10-year zero-coupon bond will appreciate 10% in price for every 1% decrease in yield while a 2-year zero-coupon bond will appreciate only 2% in price for every 1% decrease in yield.

Longer-term bond ETFs have more risk than short-term bond ETFs, but can nonetheless reap great rewards in an uncertain environment such as now where global investors are opting for fixed income. Asset manager Blackrock highlights this in a recent presentation.

As we move into 2012 with little resolved in Europe and continuing economic woes in the U.S. and Asia, I strongly believe that a majority fixed income ETF allocation is the best strategy during this period of heightened risk which is likely to extend well into next year.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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