Your Money: How to up your bond game with ETFs

NEW YORK (Reuters) – Most people’s basic knowledge of investing is that their portfolio should be a mix of stocks and bonds.

That is usually enough to get by in the stock market – pick up a popular S&P 500 index exchange-traded fund or two and you will probably do fine. But bonds are a different story because you need more specialized knowledge to understand the market forces that drive them.

“I see a lot more mistakes,” said Michael Yoder, a certified financial planner from Walnut Creek, California.

Here are some things that financial advisers say to consider when purchasing bond ETFs:

* Liquidity

Bonds are driven by duration – they are basically a contract where the buyer puts money in, gets a payout at some regular interval and then receives money at the end.

Buying Treasuries directly from the government is not liquid enough for many advisers because you can get tied up for durations that range from days to 30 years and there are transaction costs.

“If you hold a bond for five years, you’d pay less for an ETF over the same time,” Yoder said.

Certified financial planner John Middleton leans on a variety of ETFs, which trade throughout the day.

“With ETFs, you can get all that sector and timeline exposure. They carve it up pretty finely,” said Middleton, who is based in Clinton, New Jersey.

The Bloomberg Barclays US Aggregate Bond Index tracks more than 10,000 fixed-income holdings, and most fund companies have ETFs that track this index, like iShares, Schwab and Vanguard. You can also get ETFs that specify any duration you want, or you can go for all corporate bonds or all government bonds, or mortgage bonds, or bank loans.

“You can really fine-tune and dial-in a portfolio. And you get diversification immediately,” Middleton added.

* Active management vs. indexes

Advisers have not forsaken bond mutual funds, like those offered by most of the major brokerages, because they still value the active management. The fees might be a little higher, but certified financial planner Andrew Casteel, who is based in Reston, Virginia, feels like that is starting to shift a little as competition with ETFs heats up.

Ken Nuttall, a certified financial planner in New York, uses a mix of direct bonds and mutual funds for his larger accounts that have more than $500,000 in bonds. For smaller accounts, he finds it is hard to get the diversification he needs that way, so he turns to ETFs instead.

“Passive investing in bonds does not work as well as it does in stocks,” Nuttall said, noting that while there are some actively managed bond ETFs, they are hard to find and you need to do a lot of research.

* Efficiency

For funds within a tax-deferred retirement account like a 401(k) or IRA, you will not pay tax on your gains until after you cash out. But for brokerage accounts, there are tax efficiency differences that matter when it comes to choosing among Treasuries, mutual funds and ETFs.

With bond ETFs, Casteel said, “You can hold onto it and defer paying taxes in a way that mutual funds cannot,” because of the way they are structured.

Advisers also favor bond ETFs for rebalancing, especially now that many brokerages are not charging any fees for trades. “If you have 15-20 securities, and the commission was $10, now you’re saving up to $800 if you are rebalancing quarterly,” said Casteel.

* Bond ladders

One reason people used to favor buying bonds directly is that you could structure them into ladders, where the maturities would stack up, creating an income stream as the steps matured.

You can do that even more efficiently with ETFs that mimic bond ladders, said Mitch Tuchman, managing director of Rebalance. For instance, you can build a five-year ladder with Invesco BulletShares or iShares iBonds.

“You used to need millions and somebody monitoring it, but now you can have a small amount of money and do it effectively,” Tuchman said.