Putting Bonds in Your Portfolio Mix

THE STAMPEDE OF MONEY out of near-zero-paying money-market funds increasingly is heading for higher-yielding bond exchange-traded funds. Although most of these funds have jumped sharply in price, experts think value remains in several areas.

"In the corporate-bond space and junk-bond space, yields are still above historic highs," says Scott Burns, director of ETF research at Morningstar. Treasuries look pricey, he says, but Treasury Inflation-Protected Securities, or TIPS, make a good portfolio hedge right now. You can play this segment via the iShares Barclays TIPS Bond ETF (TIP).

This year through Oct. 7, as investors pulled $394.45 billion from money-market accounts, according to Lipper FMI and Morningstar figures, they have on balance put $228.73 billion into traditional taxable fixed-income mutual funds, $63.07 billion into tax-exempt funds, and $35 billion into bond ETFs. That's a 64% gain in assets for fledgling bond ETFs, which act like index funds, tracking a benchmark.

The surge in popularity has prompted sponsors to create new varieties of fixed-income ETFs, including everything from convertible-bond funds to high-yield municipal-bond funds.

"A fixed-income ETF is almost a perfect product for high-net-worth individuals," says Bill Larkin, portfolio manager of Cabot Money Management, who uses a combination of mutual funds and ETFs for his managed accounts. He says ETFs provide an investor with a way to enter fixed-income categories, like high-yield or emerging-markets debt, that "only pros could access" before. "They have liquidity, diversity and are low cost," says Larkin. Cabot manages $475 million in assets.

The average expense ratio for a bond ETF is a paltry 0.24%, reports Morningstar, while the average expense ratio for a standard bond mutual fund is 1.03%. The Vanguard Short-Term Bond ETF (BSV), for example, has an expense ratio of just 0.10%.

Not only are they cheap, but ETFs also offer a way to diversify a portfolio, reining in risk. An investor can buy shares of a total-bond-market ETF like iShares Barclays Aggregate Bond (AGG) and "set it and forget it," says Larkin. Given the huge universe of bonds in the index, no one security, if it should run into trouble, can swamp a portfolio. The Barclays index is one of the most prominent fixed-income benchmarks.

The average return for this year through Oct. 13 for fixed-income ETFs was 7.81%, according to Morningstar. In 2008, the return was 2.50%. Among the big gainers: The SPDR Barclays Capital High Yield Bond ETF (JNK) returned an eye-popping 31.06% through Oct. 13. Although not strictly speaking a fixed- income ETF, the iShares S&P U.S. Preferred Index ETF (PFF) provided a 32.88% gain over the same span. Many bond investors are also active participants in the preferred stock market.