Rules of the Game: Bond ETFs for the Stock Investor

 | Apr 04, 2013 | 11:00 AM EDT
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What do equity bulls talk about? Stock picks!

Well, I'm going off-script today. While I continue to see upside potential for equities -- and as regular readers know, equity trading is my background -- I'm also a risk manager. That means equity risk in a portfolio has to be mitigated with some other asset classes, such as fixed income.

It's a far cry from my days of "Buy seven growth stocks and sell them when the market turns lower!" But it's all part and parcel of my investing epiphany, during which I realized that the "big winner" dreams of traders can generate into a "big loser" reality pretty quickly.

And it's not necessarily because trading systems don't work. Some do, if you follow them to the letter, and if the creators don't have some "unwritten rules" that they apply on a whim.

But rather than vent about trading systems today (I can do that pretty much anytime), I want to discuss some of the fixed-income holdings at my firm, Portfolio. We remain bullish on the market for 2013, despite the inevitability of a pullback at some juncture, after the recent run-up. If we were traders, we would get ready to panic. Since we are investors, we look at pullbacks as buying opportunities.

But risk management is a key part of our investment strategy. As such, it makes sense to keep some of our moderate portfolios invested in vehicles other than equities. It's good to keep some powder dry, but it's not wise to have big piles of cash just sitting in your account, doing nothing for you.

Currently, our moderate portfolios are overweight in equities, sporting a 70% allocation to stocks and 30% to bonds. Our moderate-portfolio clients hold an allocation of 15% in U.S. corporate bonds, via the iShares Investment Grade Corporate Bond ETF (LQD). We appreciate the medium-term exposure this vehicle gives our clients.

This ETF is pegged to the Markit iBoxx USD Liquid Investment Grade Index, which was created specifically for ETFs to track the corporate bond market.

Corporate yields are generally higher than those of Treasuries that have similar maturities.

We do have exposure to government debt securities, via the Vanguard Total Bond Market ETF (BND). Here, we have a weighting of 11%. This ETF tracks the Barclays Capital Aggregate Float-Adjusted Bond Index. That index is often used as a proxy for U.S. investment-grade bonds. The ETF comprises Treasuries, mortgage-backed securities and corporate bonds.

The "float adjusted" element of the fund means that it eliminates securities held by the Federal Reserve. That translates to a mortgage-bond allocation that is lower than the better-known Barclays Capital Aggregate Bond Index, which is dubbed the Agg.

Another fixed-income ETF in our moderate portfolios is the iShares High Yield Corporate Bond ETF (HYG). High-yield bonds do have a tendency to be volatile, so do-it-yourself investors need to proceed with caution. In the current market environment, HYG has been performing well, and it merits a place in client portfolios. However, even here, restraint is in order. We currently have a small allocation, just 4%.

As you see, getting the proper fixed-income exposure requires more thought than simply loading up on a Treasury ETF. As always, it requires an analysis of your overall investment objectives, then allocating your investments accordingly. 

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