Here is an article I just completed on fixed-income ETF trading. I sent this article to our subscribers two weeks ago, but am also posting it here on ET for all you fellow ETF traders. In general, I trade the broad-based ETFs during trending market periods, while the sector-specific ETFs (HOLDRS and iShares) usually provide a better risk/reward on days when the broad market is choppy or in a sideways range. With the inception of the new fixed-income ETFs, I now have an additional tool in my trading arsenal that is an excellent vehicle for accomplishing several different trading objectives.
What is a fixed-income ETF?
Simply stated, a fixed-income ETF is an exchange traded fund that, rather than consisting of a group of underlying individual stocks, is comprised of various fixed-income instruments, most commonly bonds. This means you can now trade bonds on a short-term basis without the expense and complication that has prevented retail traders and investors from participating. In fact, placing an order to buy a group of bonds is now just as simple as placing an order to buy a stock, thanks to the new iShares® family of fixed-income ETFs from Barclay Global Investors. Letâs begin by discussing some of the benefits to trading the fixed-income ETFs.
Why trade fixed-income ETFs?
Although they were initially designed for long-term investors looking for easy access to investing in bonds, I have discovered the new Bond ETFs are excellent vehicles for short-term traders as well. While some of these ETFs may have too narrow of an intraday trading range to be easily traded on an intraday basis, they are excellent instruments to take a position in with the intention of holding for a few days or weeks. While the typical fixed-income ETF has an average daily range of only 10 â 50 cents, it will often move 1 â 2 points over the course of a week. Because they are less volatile than individual stocks, you could take a larger position size without significantly increasing your risk. As an example, I shorted both TLT (20-year T-bond ETF) and IEF (10-year T-bond ETF) as âswing tradesâ recently, held them for two days, and netted a handsome profit when the stock market rallied, which caused the price of the bond ETFs to go lower.
Do you think interest rates are going to go up? If so, you can profit from the rate increase by shorting one of the Government Treasury Bond ETFs, whose prices move inversely with their yields. Do you think that the price of bonds is due for a correction due to investorsâ flight to safety over the past several years? If so, short one of the T-bond ETFs, set your stop, and sit on it.
Prior to the inception of the fixed-income ETFs, it was difficult for individual investors and traders to have easy access to bond prices as they do with stocks. This made it difficult to verify prices paid to your brokerage firm for individual bonds. Bond mutual funds, which the average investor or trader does have easy access to, are only priced once per day, at the close of trading. This creates a problem for the trader who wants to capitalize on an intraday move in bond prices. However, the new Treasury and Corporate Bond ETFs now provide you with easy access to real-time intraday pricing of various bond indexes and you have the ability to easily buy or sell them on intraday. By trading fixed-income ETFs, you now have access to intraday trading of Government Treasury and Corporate Bonds all with the same ease of placing an order to buy or sell a common ETF such as QQQ or SPY. While placing an order to buy individual bonds through your typical discount broker will cost you about $50 in commission, your commission fee for buying a fixed-income ETF is the same as what you normally pay for a stock trade, probably around $10.
Aside from short-term trading of these instruments, there are also many benefits to those of you who are looking to invest âlonger-termâ in the bond market. The biggest benefit for investors is that, unlike individual bonds, fixed-income ETFs provide diversification with just one trade and low minimum investments (you can trade as little as one share). The expense ratios are also much lower than those associated with a typical bond mutual fund, which is usually close to 1% annually, not to mention front-end loads.
Perhaps the greatest benefit of fixed-income ETFs for long-term investors is that they are an excellent tool for hedging stock or mutual fund positions in an IRA, 401k, or other retirement account. Since qualified retirement accounts cannot use margin, it is not possible to sell short any securities in an IRA. This creates a challenge if you are looking for a way to remain invested in equities, but also desire to reduce your risk. But with the inception of the new fixed-income ETFs, you could simply buy one of the Treasury Bond ETFs as a hedge against your equity positions. Since bond and stock prices typically (not always) have an inverse price relationship, the price of your Bond ETF will rise as the value of your equities drop.
If your personal assets are sensitive to interest rate fluctuations, you can also use the fixed-income ETFs to manage and hedge your interest rate risk. Remember that all ETFs can be purchased on margin and sold short (even on a downtick), meaning you can now use interest rate risk management strategies once available only to institutional investors. For example, fixed-income ETFs can be sold short to hedge interest rate fluctuations. In a rising interest rate environment, profits from a short position can offset some of the losses in a portfolio. All the fixed-income ETFs also pay regular dividends to shareholders, just like all the other ETFs.
Are they liquid?
When you first begin trading the various fixed-income ETFs, you may be falsely under the assumption that they are not liquid enough to be traded on a short-term basis. After all, each of the iShares trade an average daily volume of only 100,000 â 200,000 shares. However, donât forget that each and every ETF, whether broad-based, sector-specific, or fixed-income, is a synthetic instrument. In other words, the market price of any ETF is not determined directly by supply and demand for shares of the ETF, but rather by supply and demand of the underlying composite of stocks or bonds. For example, even if not a single person is willing to buy or sell a single share of TLT, the bid and ask price will still move up and down throughout the day as the prices of the composite bonds changes. Therefore, getting your order quickly filled is as simple as entering a limit order, preferably in the middle of the spread.
What are my choices?
So, youâve decided you would like to research and eventually start trading and/or investing in the fixed-income exchange traded funds. What are your options? As of now, there are two companies that have brought these instruments to the market. The first and most well-known family of fixed-income ETFs is the iShares, issued by Barclays Global Investors. iShares launched the first U.S. Treasury and corporate bond ETFs in July 2002 and today the four funds' assets total over $3.7 billion. The table below summarizes these:
TICKER DESCRIPTION
SHY iShares Lehman 1 â 3 Year Treasury Bond Fund
IEF iShares Lehman 7 â 10 Year Treasury Bond Fund
TLT iShares Lehman 20 + Year Treasury Bond Fund
LQD iShares Goldman Sachs InvesTop⢠Corporate Bond
Fund
Below is a daily candlestick chart of TLT, one of the fixed-income ETFs I trade the most often. The chart gives you an idea of the volatility of the typical fixed-income ETF.
In addition to the four ETFs above, Barclays Global Investors has registered with the SEC to add a new fixed-income ETF, the CSFB Liquid U.S. Agency Bond Fund. It will consist of non-callable securities with remaining maturities of greater than one year from Federal Home Loan Banks (FHLB), Freddie Mac, and Fannie Mae.
You may also be interested to know that LQD, the GS Corporate Bond ETF, also trades options. Because LQD is currently priced at over $100 per share, this is a less expensive way to gain leverage through the same instrument. However, I do not recommend you trade options unless you already have prior experience doing so.
In November of 2002, a company named ETF Advisors launched a family of fixed-income Treasury Bond ETFs named the FITRs (pronounced âfightersâ) designed to compete with the iShares, which were launched only several months prior. However, the FITRs never gained much popularity and are much less liquid than their iShares counterparts. As such, I do not trade the FITRs, but mention them to you for your information. There are four different FITRs, each of which are Treasury Bond Indexes: 1, 2, 5, and 10-year are your choices.
Summary
While the broad-based and sector-specific ETFs provide a lot of daily trading opportunities, the fixed-income ETFs bring us a whole new dimension of strategies that are ideal for both short-term traders and long-term investors.
To learn more about the fixed-income iShares, visit
http://www.ishares.com or click here to go directly to the fixed-income section of the iShares web site. You can also visit the American Stock Exchange web site by going to
http://www.amex.com for details on all ETFs, both securities and fixed-income.
