Exchange-traded funds, which resemble index mutual funds but are bought and sold like stocks, have been a big hit with equity investors. Now, Wall Street is trying to apply the same concept to bonds. ETFs tracking indexes of U.S. government bonds and other high-quality issues are expected to start trading by early next year.
Even with investors' newfound enthusiasm for bonds, these new fixed-income vehicles are not likely to enjoy the same success of equity ETFs such as "Spiders" or SPDRs (Standard & Poor's Depositary Receipts), which track the Standard & Poor's 500-stock index. For one thing, they are not nearly as diversified as bargain-priced index mutual funds that cover much of the bond market. Moreover, the tax advantages that have helped make stock ETFs hot items do not travel well to the bond market. "I've yet to see a compelling reason for why investors need them," says Eric Jacobson, senior analyst at Morningstar, the Chicago-based firm that tracks mutual-fund performance.
FIRST WAVE. Trading bond-fund shares on a stock exchange is not exactly a new idea. Several hundred closed-end bond funds are already available to investors. But these older funds are problematic for many since the price at which they trade can be significantly different from net asset value (NAV)--what the fund's bonds are actually worth. In contrast, the new ETFs are structured so that they rarely deviate from NAV. That's because if an ETF swings to a discount, middlemen buy the beaten down ETF shares and exchange them with the ETF's sponsor for the more highly valued component bonds. That way, the middlemen net an immediate profit and keep the share prices in line.
Barclays Global Investors and Nuveen Investments, sponsors of the bond ETFs, will bring them out under the respective names iShares and Fixed Income Trust Receipts, or FITRs. Nuveen plans to offer portfolios that mature at 1-, 2-, 5-, and 10-year intervals (table). Barclays aims to launch five funds. One will track the entire Treasury market. Three others will zero in on specific maturities. And the last will add some agency- and investment-grade corporate bonds to a mix of Treasuries.
Neither Barclays nor Nuveen has yet announced the management fees they will charge for the bond ETFs. A good bet is that they will be slightly below the lowest-cost bond index funds, which charge fees in the range of 0.20% of assets. And they will be far below the fees levied on closed-end bond funds. Roll in the brokerage commissions, and the costs probably will be a little higher than just buying and holding Treasury bonds. Still, some investors may think a slightly higher cost is worthwhile, given the liquidity and convenience of the ETF format.
Like most bond funds, these ETFs won't pay you a fixed rate of return or guarantee that your investment will be recouped when you sell. Instead, you will get whatever price the ETF fetches on the exchange. If interest rates have gone up since you bought, the price will have gone down. If rates have fallen, the price will be higher.
Since the first wave of bond ETFs focuses almost entirely on Treasuries, you'll have to go elsewhere to invest in other sectors, such as municipal and high-yield debt. The broadest-based bond ETF, the iShares Government/Credit Bond Index Fund, covers only 60% of the Vanguard Total Bond Market Index Fund's terrain. If the initial products find acceptance, Barclays, Nuveen, and others will likely roll out new bond ETFs to fill the gaps.
It's hard to see a big success here. One attraction of stock ETFs over mutual funds is that they're structured in a way that often allows them to avoid making the taxable capital-gains distributions that rankle fund investors. But bond funds generate nearly all their returns from interest income--and there's no way to avoid paying tax on that unless, of course, the income is from tax-exempt bonds.
Even if the bond ETF isn't a killer app, it may have some appeal to those looking for a low-cost, low-maintenance play in high-quality bonds.
By Anne Tergesen