Wednesday, October 18, 2006

The Case for Bonds: Part II In the Aggregate

The current bond ETFs can be split into two groups. The treasury yield curve group and the asset class groups. iShares Lehman 1-3 Year (SHY), iShares Lehman 7-10 Year (IEF), and iShares Lehman 20+ Year (TLT) cover the short, intermediate and long portions of the treasury yield curve. Unlike bonds themselves, ETFs are perpetual instruments, and so you can't ignore market price risk. Because of the ability to dynamically position themselves and hedge exposure active bond funds may be less volatile than the benchmark.

The longer treasury ETFs are mostly good for speculating on the treasury yield curve. In the current inverted yield curve environment, SHY is hopelessly dominated by money market funds with zero duration.

The asset class bond ETFs (AGG,LQD,TIP) each represent the exposure to an entire area of the investment grade universe. (LQD) to liquid corporate bonds and the (TIP) to TIPS universe.

The Lehman Aggregate (AGG) is the benchmark for most investment grade bond funds. Based on the total investment grade market, it is heavily weighted towards short term US treasury and government agency securities. AGG sits in the sweetspot of very low credit risk, reasonably short duration and attractive yield. The aggregate is the underlying index for the popular Vanguard Total Bond Market Index Fund (VBMFX). If you don't want to fuss with active management, AGG is probably your best choice for an ETF bond allocation.


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