Case Summary

Fran is rebalancing her portfolio after the recent market turmoil and wants to simplify her fixed income investments.  Her previous financial advisor was recommending individual bonds issued by banks that are now either out of business or severely weakened by the financial crisis.  She’s learned her lesson – diversification is more important than an extra few basis points of yield.

She knows that fixed income is an important part of any retirement portfolio, but is a little overwhelmed with the choices and amount of work it takes to evaluate individual bonds.  She would also like her investment portfolio to be more cost and tax efficient.

Analysis

Fran will need to decide how much of her portfolio will be allocated to fixed income and which types of bonds to include.

The fee-only National Association of Personal Financial Advisors (NAPFA) recommends investing in both stocks and bonds to improve your chances of reaching your financial goals.  Case in point – although stocks have historically outperformed bonds, that has not been true for the past three years.  To choose the right mix, NAPFA recommends working with a financial advisor to find the best combination of assets for your risk tolerance, investment time horizon and financial goals.

Money Magazine’s retirement advisor recommends a variety of bonds be included in the fixed income portion of a portfolio.  At a minimum, investors should have a mix of government and corporate bonds and perhaps, depending on the tax situation, tax-free municipal bonds.  More sophisticated portfolios may also include non-investment grade (junk) bonds and international bonds.

Investors seeking to construct a fixed income portfolio with exchange traded funds have more choices today than ever before.  Exchange Traded Funds offer instant diversification as well as transparency, flexibility and low cost.

Portfolio Recommendations

The place to start with a fixed income ETF portfolio is with a long term government bond fund.   The $2.1 billion Barclays Capital 20+ Year Treasury Bond Fund (TLT) seeks to approximate the total rate of return of the long-term sector of the United States Treasury market.   Over 98% of the fund is invested in U.S. government bonds and the ETF carries an expense ratio of 0.15% and has a weighted average coupon of 4.67%. An ETF with similar investment, expense and coupon characteristics is the Vanguard Extended Duration Treasury ETF (EDV).

Another safe-have government bond investment is treasury inflation-protected securities or TIPS.  The $15 billion Barclays Capital TIPS Bond Fund (TIP) tracks an index that includes all publicly issued, U.S. Treasury inflation-protected securities that have at least 1 year remaining to maturity, are rated investment grade and have $250 million or more of outstanding face value.  The fund carries an expense fee of 0.2% and an average yield-to-maturity of 3.34%.  An ETF similar to TIP is the SPDR Barclays Capital TIPS ETF (IPE) which carries a slightly lower expense ratio of 0.1845%.

Investors who want a more streamlined approach may be interested in an “aggregate” bond fund which invests in both government and corporate bonds with the goal of representing the overall bond market.  The Barclays Capital Aggregate Bond Fund (AGG) tracks the performance of the U.S. investment grade bond market including investment grade U.S. Government bonds, investment grade corporate bonds, mortgage pass-through securities and asset-backed securities that are publicly offered for sale in the United States.  Similar ETFs include the SPDR Barclays Capital Aggregate Bond ETF (LAG) and Vanguard Total Bond Market ETF (BND).

For additional information on fixed income ETFs including High Yield ETFsTax-Exempt ETFs andInternational Fixed Income ETFs, see the Fixed Income ETF Directory.