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Bonds and bond ETFs are not the easiest area of financial markets to understand. The good news is, you don’t need to be an expert in the intricacies of bond math to understand how they may (or may not) benefit your portfolio.
For the purposes of this post, we are going to simply focus on bonds role as:
1) A potential way to diversify from stocks.
2) An investment option that typically displays lower volatility than stocks and stock indices.
We will then profile the largest and most popular types of bond funds in the iShares family of ETFs (all available on the Robinhood app), so you can better understand which type of bond and ETF to select if you decide bonds have a place, however small, in your portfolio.
Bonds: Basic Use Cases and Further Reading
Bonds have a variety of uses across different portfolios. Institutional investors, pension funds and governments are all major holders of bonds. When it comes to Robinhood investors and most Reddit forums, bonds are largely viewed as unfashionable and boring. However, bonds can be a very useful diversifier and provide support to a stock-heavy portfolio. On days when the stock market gets crushed and your portfolio is a sea of red, often (but not always) bonds will hold steady or even appreciate, depending on the type of bond fund or ETF you hold.
The famous 60/40 portfolio is built upon the idea that a mix of stocks (60%) and bonds (40%) will outperform an all-stock portfolio on a risk-adjusted basis over the long-term. Others have found success with a 50/50 mix of the S&P 500 (stocks) and TLT (long-term US treasury bonds) ETFs, benefiting from the negative correlation of these two asset classes in providing a stable and consistent return with limited drawdown periods compared with a portfolio of either of the two ETFs alone.
Before investing in bonds, you should be aware there are two primary types of risk to assess: credit risk and duration risk. Credit risk relates to the issuer of the bond. Are they rock solid like Apple, or on shakier ground, like Lordstown Motors? The difference in credit quality between the issuer will determine the yield, or how much the bond will pay out. Riskier issuers need to pay higher yields to investors to compensate them for the risk taken. This holds true for governments as well: German bonds will pay a much lower yield than a bond from Venezuela.
Duration risk, on the other hand, relates to how long the term of the bond is issued for. Bond prices are greatly influenced by interest rates and rising interest rates are bad for bond prices. The longer the duration of the bond you hold, the more likely your bond will be impacted by interest rate changes (either up or down). Assessing the interest rate environment is a key factor in determining whether you should hold short-term bonds (3 years or less) or if you’re comfortable holding longer duration (10 or even 20 year bonds).
There is a lot more research you can do on bonds to better understand them. Here are some helpful links to dive deeper:
Below we profile some of the most popular bond offerings from iShares that will provide a very basic overview of the different types of bonds and how some investors utilize them. We provide a very basic assessment of how volatile the ETF has been historically (how much the returns have fluctuated up and down) and also provide the 2008 return for each to see how these ETFs weathered the greatest stress test of our lifetimes. As a reminder, most major stock funds lost between 30-40% in 2008.
Keep in mind that even with bonds, past returns are no guarantee of future results. Many market watchers suggest that the relatively calm and steady returns experienced by most bond funds are at risk as the interest rate environment is expected to be less friendly for bond returns going forward. For more discussion on the potential end of the long bull market in bonds, see this story in MarketWatch for an introduction to the debate.
iShares Core US Aggregate Bond ETF (AGG)
Diversification from stocks: Medium
2008 return: +5.88%
AGG is the ultimate fund for discussing “bonds” in general. That’s because it incorporates almost every different type of US-issued bond there is: corporate investment grade, high-yield, treasuries and mortgage bonds, with a very small slice of municipals as well. This broad diversification is both a strength and a weakness. It means that if one part of the bond market is experiencing distress, holders of this ETF shouldn’t be too concerned as other types of bonds will hopefully perform better. A case in point is AGG’s positive 2008 performance, despite the fact it held a significant chunk of mortgage bonds. Investors fleeing those bonds as well as stocks piled into treasuries (also well represented in AGG) and the ETF actually returned more than 5% in 2008.
On the other hand, it’s difficult to use this fund to achieve specific goals related to credit or interest rate sensitivity because it has such a wide variety of different types of bonds.
However, if you are looking for a simple bond fund to plug in for the “40” of your 60/40 portfolio, AGG has proven to be a popular and durable choice with investors for this purpose.
iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)
Diversification from stocks: Low
2008 return: -0.33%
LQD is a much more focused bond ETF that only invests in bonds issued from companies, and those that are rated financially sound by bond rating agencies such as Moody’s and the S&P. Investing in investment grade companies is typically the way investors combat credit risk. Like everything in investing, there is a trade-off; by investing in the bonds of only healthier companies, you typically must accept a lower overall rate of return.
There is an added factor that is less well understood by novice investors in bonds. By exclusively investing in corporate bonds—even the very healthy ones represented in LQD— you are losing some diversification that treasuries, mortgage and municipal bonds provide, particularly when there’s stress on the corporate sector. This means that LQD may not always provide the type of negative correlation to stocks that investors may be counting on. Take a look at the 2008 performance of LQD, basically flat, compared to the healthy positive return of AGG during the same time period.
iShares iBoxx $ High Yield Corporate Bond ETF (HYG)
Diversification from stocks: Very low
2008 return: -23.88%
HYG represents the opposite end of the spectrum from LQD: high-yield bonds, also known on Wall Street as “junk” bonds. Investors in HYG must understand that they are investing in troubled companies, some of which will ultimately default and fail to pay back their loans. HYG is even more volatile than LQD during times of corporate crises and will sell off when stocks do, although usually not as drastically. On the other hand, when times are good and the economy is in a state of expansion, high-yield bonds can be a very profitable tactical play. Investors should keep the 2008 performance of HYG (down almost 24%) in mind before investing and understand that HYG is not an appropriate diversifier for stocks.
iShares Long-Term Treasury Bond (TLT)
Volatility: Very high
Diversification from stocks: High
2008 return: +33.76%
If anyone says “bonds are boring” introduce them to TLT, which will offer investors a wild ride, particularly during times when interest rates are fluctuating. That’s because TLT is the longest duration mainstream bond ETF out there, investing in bonds with 20 year + durations. This means big returns for when interest rates are declining (including a nearly 34% gain in 2008!) and equally bad losses when interest rates start moving up.
So while TLT provides volatile returns similar to HYG, unlike the latter it tends to perform well when stocks are declining, making it a relatively attractive option for diversification from stocks. That’s because TLT invests only in treasuries or US government bonds, taking the corporate credit risk we discussed in HYG, LQD and AGG out of the equation. When stocks and high-yield bonds are melting down, investors typically “flee to safety” and TLT is viewed as safety. However, when stocks are doing well, safety goes out the window and TLT holders can feel a lot of pain.
Investors should be aware that this fund is capable of providing double digit returns in any given year, either positive or negative. So for those seeking a calm ride from their bond holdings, look elsewhere.
iShares Short-Term Treasury Bond ETF (SHV)
Volatility: Very low
Diversification from stocks: Medium
2008 return: +2.78%
That “calmer ride” is SHV, the much shorter duration ETF that invests only in US treasuries. SHV avoids the huge swings in returns you get from TLT, which is both the advantage and disadvantage. SHV rarely provides annual returns much beyond inflation, but doesn’t surprise investors with significant annual losses, either. It provided a non-negligible positive return in 2008 and could be a good option for investors who want to avoid credit risk from corporate bonds and just need a little support for their portfolio when stocks are getting hit.
iShares TIPS Bond ETF (TIP)
Diversification from stocks: Medium
2008 return: -2.52%
An increasingly popular option with investors concerned with inflation and/or rising interest rates, the TIP ETF provides investors with a way to benefit from rising inflation. TIP consists only of inflation-protected treasury securities that are indexed to the Consumer Price Index (CPI). If inflation or even the anticipation of inflation occurs, TIP should perform well. However, the reverse is also true and times of disinflation or deflation can lead to losses. 2008 was an example of this and the fund lost nearly 9% in 2013.
TIP is typically used as a tactical bet on rising inflation and wouldn’t be appropriate for use as a sole bond ETF in a 60/40 portfolio. The returns are somewhat volatile and highly dependent on the macro environment and TIP is not a consistent diversifier for stocks.
We hope you learned from this basic summary of bond ETFs and some of the most popular mainstream choices out there. We did not cover municipal bonds (typically used by wealthy investors to manage tax issues) or international bonds, but we will cover those in a future article.