You’ve finally reached a decision regarding the equity component of your portfolio but aren’t sure on how to proceed regarding the fixed income part. You are looking to reduce the volatility of your portfolio but are not sure how to go about choosing a bond ETF.
You shouldn’t invest in anything you don’t understand. The Bogleheads wiki is a great starting point to learn about bonds.
When choosing a bond ETF you should understand the assets the fund holds. Those assets will affect your risks (interest rate and credit) as well as your returns. Below are a few things I think you should consider when choosing a bond ETF.
Note that whenever a risk is mentioned, it is generally assumed that undertaking greater risks will be compensated by the market with higher returns.
Weighted Average Maturity
A bond ETF may hold bonds of different maturities: short term (< 3 years), intermediate term ( > 4 years, < 9 years), long term ( > 10 years). The average maturity will weight all maturities of the underlying bonds into a single number. The longer the maturity the longer your exposure to interest rate and credit risk.
Choosing between short term and intermediate term bonds is usually recommended as long term bonds have historically not returned more than intermediate term bonds while leading to more risk.
Duration is a measure of interest rate risk. Lower durations lead to lower interest rate risk. You should keep duration less than or equal to your investment horizon.
Credit risk measures the likelihood of the bond issuer having a default. Issuers with higher credit rating (e.g. AAA) have lower credit risk than issuers with lower credit rating (e.g. CCC).
Since a bond fund may hold multiple bonds, you should check the breakdown of the fund’s bonds credit quality ratings at the fund’s website.
Note that “event risk” (e.g. due to a country leaving the Eurozone) is a type of credit risk which you may have to account and may not be reflected in the credit rating.
Generally, bonds with better credit quality are preferred (e.g. government bonds being the safest). Bonds with lower credit quality may increase your return but you should be aware of the risks you are taking.
Different bond types – government, corporate, municipal – have different credit risks. Government bonds tend to be the safest. Note that corporate bonds correlate highly with the equity portion of your portfolio which may be undesirable for your portfolio. Corporate bonds don’t perform great in the event of a serious financial crash.
MorningStar Style Box
The MorningStar Style Box can give you an overview of the bond ETF’s credit quality and interest rate sensitivity. It takes Effective Duration, Credit Risk, Weighted Average Maturity and translates it into a diagram making it easier to compare alternative bond funds.
Weighted Average Coupon
The weighted average of the coupons (annual interest rates) of the underlying bonds.
Weighted Average Yield to Maturity
The yield to maturity is the expected internal rate of return if you were to buy the bond ETF today and hold it until maturity. This is the best estimate of the returns you will get by investing in the bond ETF so you should pay special attention to this number. Note that it does not include fees, expenses, inflation. It is weighted to account for the fact that the bond ETF may hold different bonds.
Comparing this number to the “Weighted Average Coupon” will give you an idea if the bond is selling at a discount or premium.
The ratio of distributed income over a year. This gives an idea of how much you can expect to receive in dividends. Whenever you don’t have the “yield to maturity” this may be your best indicator of expected returns (it won’t account for interest rate changes).
Currency risk measures the likelihood of exchange rate changes in foreign currency from affecting your returns. You’re exposing yourself to this risk whenever you hold assets which aren’t in your currency. These risks are really important to be aware of when investing in bonds because bonds don’t have that much volatility so, currency changes would have a bigger impact on your returns.
In order to minimize currency risk, you should hold bond funds which are hedged to your currency or which hold assets denominated in your currency. You may decide to hold funds in a different currency if you plan to have expenses in the future in a different currency (e.g. retirement in a different country than your current one).
Where to find this information?
Some of this data may be hard to find (e.g. yield to maturity) so you might have to look in multiple places for it (Google is your friend). The fund’s page along with the accompanying documents (e.g. factsheet, KIID, prospectus) should be your first stops. ETF screener’s like MorningStar or justETF may also have some of the information.
Other Fixed Income sources
Ultimately bond funds are part of the fixed income portion of your portfolio. Therefore, you should compare them with other alternative investment vehicles with similar characteristics. For example: When choosing bond ETFs compare their yield to maturity with the highest interest rate you can get on a savings account. A savings account within the insured amount by the State has no interest rate or credit risk (which bond funds have), therefore it might be a better investment than some bond funds under the current negative yielding bonds environment.