Fixed-Income ETFs Shine as Bond Market Gets Attractive

Look past equities for a moment and you'll notice that bond investing is finally growing up. Long a clubby world of illiquidity and high transaction costs; both improved technology and investor demand have contributed to a major transformation in fixed income. The NYSE (NYX) and other exchanges are upgrading their bond capabilities, and online platforms such as MarketAxess (MKTX), an online trading platform for bonds, have boomed.

Central to this effort, particular among individual investors, has been the successful introduction of fixed-income ETFs. Back in 2002, we called the recently introduced funds "a major opportunity for income investors looking to take their game to the next level." Back then, most bond ETFs held only government debt, but in the subsequent five years, more than 14 new funds have begun trading, each allowing immediate access to various parts of the bond market. A few of the newer releases merit some attention, if not potentially some investment dollars.

The most appealing of the bunch is the iShares Lehman 1-3 Year Credit Bond Fund (CSJ), which holds 83 short-term corporate bonds with an average maturity of two years. Paper from General Electric (GE), DaimlerChrysler (DCX) and Citigroup (C) are all among the top 10 holdings. The fund pays monthly dividends and currently yields about 4.85%.

At a time in which most long-term bonds are barely yielding more than short-term ones, this fund offers a modest pickup in yield compared with similarly dated Treasurys. If you are sitting on the sidelines, a position in CSJ exposes you to only moderate credit risk and very low interest rate risk. A modest position is a conservative way to boost an income-oriented portfolio that's primarily in money markets, CDs or government debt.

Of course, there is risk in every investment, even bonds. If short-term rates begin to rise or if credit conditions worsen, CSJ will fall. To that end, those pessimistic investors who foresee higher interest rates and increased nonperforming loans might consider selling the shares short.

When it comes to worsening credit conditions, no sector of the bond market has been hit as dramatically as subprime mortgages, whose implosion was largely responsible for last month's drop in stocks. Ironically launched in the midst of the meltdown was the iShares Lehman MBS Fixed-Rate Bond Fund (MBB). For those unaware of the acronym, "MBS" is short for mortgage-backed security.

The growth in agency-issued mortgage-backed securities has been dramatic, rising from $23 billion in 1980 to more than $2 trillion by 2003, according to data from the Securities Industry and Financial Markets Association. Mortgage-backed securities now represent about 35% of the widely followed Lehman Brothers Aggregate Bond Index, which is the benchmark measure of bond-market performance. To that end, MBB tends to move like other bonds, showing a strong 0.93 correlation to iShares Lehman Aggregate Bond (AGG), which follows the index of the same name.

The fund doesn't hold subprime, no-money-down, Carlton Sheets-type of debt, but investment-grade mortgage-backed securities from government-sponsored enterprises like Ginnie Mae, Fannie Mae (FNM) and Freddie Mac (FRE), meaning the credit quality is high. The expense ratio is 0.25%, and like most index products, the fund does not hold every security in the underlying benchmark, but rather invests in a representative sampling that should closely mirror the underlying return.

When it comes to successful investing, very often it's all about the timing. And even though MBB doesn't carry the credit risk of subprime loans, one has to wonder if now is the optimum time to be putting capital into most anything related to housing and real estate. REITs, which we covered in detail since their bull market began back in 2001, have now become favorite targets of cash-rich private equity firms, one sign their bull market might have finally ebbed. And after a short dead-cat bounce, home-building stocks like Hovnanian Enterprises (HOV), Beazer Homes (BZH) and Lennar (LEN) are once again some of the weakest names on the board. At my firm, we've stuck with RMR Asia Pacific Real Estate Fund (RAP) but have not added new exposure in the sector.

Even shares of MBB have been a loser since its IPO lost money, notching a new low of $100.39 last week. Given those conditions, this might be one income exposure to monitor, rather than buy in the current market environment.

Most recently launched is the iShares iBoxx $ High Yield Corporate Bond Fund (HYG), which began trading just last week on the American Stock Exchange. High yield means high(er) risk. The fund holds junk bonds, including many of those engineered by the recent explosion in private equity activity like Hertz Global Holdings (HTZ), Neiman Marcus and RH Donnelley (RHD).