Best Bond Funds for 2017
At Income Investors, we love stocks that pay solid dividends. But that doesn’t mean investors should ignore bonds completely. As one of the most common types of fixed income instruments, bonds have been playing a crucial role in many income investors’ portfolios. A great way for individual investors to tap into the bond market is to invest in bond funds. In this article, we are going to take a look at the best bond funds for 2017.
Why Should Investors Consider Bond Funds?
A bond is a debt investment. When an investor holds a bond, they are lending money to an entity which borrows the funds for a defined period of time at a given interest rate. Typical entities that issue bonds are federal governments, local municipalities, and corporations.
Because the coupons are predetermined, it seems that bonds can provide certainty to an income investor’s portfolio. However, they are far from risk-free. The most obvious risk is the default risk. As is the case with any lending and borrowing, there is a chance that the borrower does not pay the lender back. When it comes to bonds, the risk is that the bond issuer may not be able to make the required coupon payments or principal repayment to the bondholders.
Of course, there are a lot of bond issuers that have the ability to make the required payments. However, as we have seen during the sovereign debt crisis, even government bonds can carry a significant amount of risk. That’s why it’s important to take into account the default risk when investing in these fixed-income securities.
One thing that income investors will definitely want to do when it comes to bond investing is diversify. Think about it: if an investor puts all their savings into one bond investment, they are lending out all the money to a single borrower. If that borrower doesn’t pay back for whatever reason, all of the investor’s savings could be gone.
Inflation is another thing that bond investors need to keep in mind. Inflation means an increase in the general price level of goods and services in an economy. If inflation is high, an investor who is collecting a fixed amount of payment from bonds every year will see their purchasing power erode over time.
And then there’s the interest rate risk. When market interest rates increase, the value of a bond will decrease because the bond’s predetermined coupon payments will be lower than the amounts available in new bonds issued at new market interest rates.
That’s why when it comes to bond investing, it might be worthwhile to consider bond funds. Because bond funds usually hold a large number of bonds, they provide the benefit of diversification. If an individual investor were to build a portfolio of bonds by themselves, it would require a significant amount of capital to achieve the same level of diversification. Moreover, there are different types of bond funds geared towards different types of investors. If an investor wants exposure to only government bonds, there are bond funds specializing in that. In addition, bond funds regularly provide investors with dividends (many distribute on a monthly basis) and can be bought and sold easily through a brokerage account.
There is a particular subset of bond funds that could be of interest to income investors—exchange-traded bond funds, or bond ETFs. These are bond funds that are traded on stock exchanges. Bond ETFs trade throughout the day, and usually charge much lower fees than their mutual fund counterparts. Moreover, bond ETFs offer more transparency than most other types of bond funds, as they reveal their underlying holdings on a daily basis.
Bond Funds Outlook 2017
If an investor plans to hold a single bond until maturity, then the credit risk of the bond issuer is perhaps the most important factor to pay attention to. However, when it comes to bond funds, it’s critical to take into account what’s going on in the macro environment.
One of the most important things to consider for bond funds in 2017 is interest rates. In the U.S., interest rates have been rising. The first rate hike after the 2008 financial crisis happened in December 2015. The U.S. Federal Reserve raised its benchmark interest rates again in December 2016, and then again in March 2017. Higher interest rates can put downward pressure on bond prices, causing their yield to go up. However, keep in mind that in many other developed economies, interest rates are still kept artificially low.
Inflation could also become more substantial. According to the Federal Reserve Bank of St. Louis, the five-year, five-year forward inflation expectation rate for the U.S. is now at 2.07%. While the number is not really high compared to periods of hyperinflation, a few percentages of increase in the price level every year could add up and result in substantial erosion in spending power in a decade or two. Moreover, higher inflation could also lead to more hawkish moves from the U.S. Federal Reserve. (Source: “5 Year, 5-Year Forward inflation Expectation Rate,” Federal Reserve Bank of St. Louis, last accessed April 19, 2017.)
Another thing that bond fund investors should keep in mind is uncertainty and its potential impact on financial markets. All three major indices of the U.S. stock market have soared past their all-time highs in the past 12 months, but uncertainty has been increasing recently. Who knows if the stock market could handle the next unexpected geopolitical headline? And if the stock market enters a correction, it could make safe assets like bonds more appealing.
Still, despite the trend in interest rates and inflation, investing in bond funds in 2017 could help investors achieve their goals. Bond ETFs can help investors diversify their portfolio, mitigate stock market volatility, and even boost their long-term income stream. For those that are searching for the “best bond funds to invest in,” here is a look at my five best bond funds for 2017.
List of Bond ETFs
|Bond ETF Name
|Management Expense Ratio (MER)
|iShares National Muni Bond ETF
|Vanguard Short-Term Bond ETF
|Vanguard Short-Term Corporate Bond ETF
|iShares TIPS Bond ETF
|iShares J.P. Morgan USD Emerging Markets Bond ETF
1. iShares National Muni Bond ETF
iShares National Muni Bond ETF (NYSEARCA:MUB) seeks to track the investment results of the S&P National AMT-Free Municipal Bond Index. It pays a monthly dividend with an annual yield of 2.2% and has an expense ratio of 0.25%.
As the name suggests, MUB ETF focuses on U.S. municipal bonds. It has $7.88 billion in assets under management and currently holds more than 3,000 bonds in its portfolio.
One thing to note about municipal bonds is their potential tax advantage. This municipal bond ETF could help investors generate an income stream that is not subject to U.S. Federal and alternative minimum taxes.
The bond fund is well diversified. Its biggest bond holding, a tax-backed bond from California State, accounts for just 0.34% of its portfolio. The ETF also invests in bonds with relatively good credit quality; 23.07% of its holdings are AAA rated, 55.84% are AA rated, and 16.23% are A rated, while only 4.06% are BBB rated. (Source: “iShares National Muni Bond ETF,” iShares, last accessed April 19, 2017.)
MUB ETF has a weighted average maturity of 5.54 years, which is shorter than most bond ETFs, making it less sensitive to interest rate increases.
2. Vanguard Short-Term Bond ETF
With rising interest rates and possibly higher inflation, investors may want to consider short-term bond funds. Vanguard Short-Term Bond ETF (NYSEARCA:BSV) is a bond fund that tracks the Bloomberg Barclays U.S. 1-5 Year Government/Credit Float Adjusted Total Return Index. The index is market-weighted, and includes investment grade bonds with dollar-weighted average maturity of between one and five years.
BSV ETF follows a passively managed, index sampling approach. It currently holds 2,446 bonds in its portfolio with an average effective maturity of 2.9 years and average duration of 2.8 years. (Source: “Vanguard Short-Term Bond ETF,” The Vanguard Group Inc, last accessed April 19, 2017.)
The fund has a management expense ratio of 0.9%. It pays monthly distributions with an annual yield of 1.36%. While the yield is nothing to brag about, keep in mind that high-yield bond funds may not be the best bond funds for income investors.
3. Vanguard Short-Term Corporate Bond ETF
When it comes to index funds, few companies offer less expensive solutions than Vanguard. And again in typical Vanguard fashion, Vanguard Short-Term Corporate Bond ETF (NASDAQ:VCSH) has a management expense ratio of just 0.07%, which is 91% lower than the average expense ratio of bond funds with similar holdings.
VCSH ETF seeks to track the investment results of the Barclays Capital U.S. 1-5 Year Corporate Index. The index includes U.S. dollar-denominated, investment grade-rated bonds issued by industrial, utility, and financial companies.
The bond fund has $21.8 billion of total net assets and holds more than 2,000 bonds in its portfolio. The average effective maturity of its holdings is three years, while the average duration is 2.8 years. Both figures are the same as the index the fund tracks. (Source: “Vanguard Short-Term Corporate Bond ETF,” The Vanguard Group Inc, last accessed April 19, 2017.)
VCSH ETF pays monthly dividends with an annual yield of 2.12%.
4. iShares TIPS Bond ETF
Things are getting more expensive. One way for bond investors to protect themselves from rising inflation is investing in Treasury inflation-protected securities (TIPs). TIPs are treasury securities that are indexed to inflation, which is measured by the Consumer Price Index (CPI). The face value of a TIP increases with inflation.
iShares TIPS Bond ETF (NYSEARCA:TIP) is a bond ETF that specializes in inflation-protected securities. It tracks the investment results of the Bloomberg Barclays U.S. Treasury Inflation Protected Securities Index. The fund pays monthly distributions with a 2.74% yield and has a management expense ratio of 0.2%
TIP ETF’s portfolio currently consists of 36 holdings. Of those holdings, 98.72% are U.S. Treasuries, with the remaining 1.28% invested in cash and derivatives. The weighted average maturity of the bond fund is 8.33 years, while the effective duration is 7.6. (Source: “iShares TIPS Bond ETF,” iShares, last accessed April 19, 2017.)
5. iShares J.P. Morgan USD Emerging Markets Bond ETF
The bond funds we looked at so far include investments in the U.S. For bond market investors that want international exposure and particularly exposure to emerging markets, iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEArca:EMB) is worth taking a look.
EMB ETF tracks the J.P. Morgan EMBI Global Core Index. The index is a U.S.-dollar-denominated benchmark that tracks the total return of actively traded external debt instruments in emerging economies. The fund provides investors access to sovereign debt of more than 30 emerging market countries. It charges an annual fee of 0.4% and has a quite handsome yield of 4.66%. The fund distributes on a monthly basis. (Source: “iShares J.P. Morgan USD Emerging Markets Bond ETF,” iShares, last accessed April 19, 2017.)