How To Buy A Bond ETF In This Market

Posted on August 14, 2013 at 10:50 AM PST by

It’s not hard to find scary headlines about the bond market these days. Interest rates are scraping along historic lows and bond prices are very high as a result. Bond ETF buyers are not exempt.

To novice investors, this can be a tricky concept, but it make sense: A bond issuer likely to pay the money back gets to pay a lower  interest rate. Demand for debt of that quality means prices are higher.

bond ETF

The trouble for bond investors now is that very low rates imply a high risk of bond prices falling in the future. If they need to sell a bond, there’s a chance they will get less for it.

You might say, “Well, just hold the bond.” Except that, at current rates, many bonds pay less than the inflation rate. It’s an automatic loss. Your money is safe, but only just.

If inflation accelerates, things get worse. You lose even more money as your capital is returned in the future with less purchasing power.

So, in a nutshell, that’s why so much hullabaloo over bonds. Buying a bond ETF can bring you diversification, but it’s not the whole answer. Instead, consider these tactics for spreading out bond risk:

1. Buy a mix of bond durations

Nobody said you had to buy only U.S. Treasuries out to 30 years. There’s a feeling of security in long U.S. debt, but the longer the duration the more you should be getting in return. Current long U.S. debt pays a low rate, so buying a lot of it locks you into the inflation conundrum. Instead, consider tranches of shorter debt that you can more easily sell as interest rates rise over time.

2. Buy lower quality, higher yield bonds

“Junk” bonds have a bad name. Some investors prefer to call them “high yield.” But they have a place in many portfolios. Sure, the risk of loss is higher, but the rates junk bonds pay are higher to compensate. Here, a bond ETF can really protect you from the occasional lapse by spreading out your holdings over many positions and durations.

3. Own foreign bonds

Home bias is strong. We tend to focus on U.S. government debt as if foreign government bonds, or “sovereigns,” were completely unreliable. Some are, but many countries issue perfectly safe debt of various durations. A well-run foreign bond ETF can help you stake out a higher rate of return while minimizing risk.

4. Own “bond-like” income investments

Bonds are a great counterweight to fluctuations in general stock market values. But so are dividend-paying stocks such as telecommunications and utilities companies. Purchased at a reasonable price, these types of stocks often pay several times over the income of bonds and offer you a solid flow of investable cash at a reasonable level of risk.

5. Rebalance, always

You cannot and will not outguess the bond market experts. Programmatically selling high and buying low with discipline, which is rebalancing, is the key to protecting your portfolio from unnecessary risk.