Fixed Income ETFs: Understanding Potential Drawbacks & Returns

If you choose to invest in a fixed income ETF, the downside is the amount of return that you will receive. Fixed income ETFs are based on returns that track the underlying fixed income, or bond indices. These index returns are much lower than those that you would expect for equity based index ETF.  

Who Uses Fixed Income ETFs?

Fixed income ETFs are most commonly used by investors with a short investment periods. They provide a safety feature similar to bonds, although you are investing in the performance of the index in an ETF. This removes some of the investment risk associated with direct investing. Any investment holds the risk of loss so be sure you are comfortable with the potential loss amount.

Looking at the risk profile of a fixed income ETF investor you will find that they have 5 or less years to realize an investment goal or objectives. They need the protection of their principal in order to generate income to fund retirement or other later life needs where other income sources may have stopped. Fixed income ETF investors may also be long term investors that are looking to diversify some of their downside portfolio risk through the use of a bond component. Bonds react opposite of stocks and their returns offer balance in a portfolio against the volatility risk that is present in investing in a portfolio of strictly stocks.

Risk/Reward Tradeoff

This downside is the tradeoff between safety and reward. The risk reward tradeoff is one of the principles of efficient portfolios. Creating a balance between assets that respond differently to market conditions produce a predictable rate of return by balancing inherent investment risks. Cash and instruments, such as treasury bills, are considered risk-less investments and are used as a baseline to gauge the relative returns of other assets such as bonds, and more riskier investment asset classes such as oil, timber and gold.

An advisor would never recommend investing in any 1 asset class such as fixed income securities. If you purchase strictly fixed income ETFs you expose yourself to concentration risk by relying solely on the performance of the fixed income index underlying the ETF.

Using Fixed Income ETFs in a Portfolio

In addition to their use as a short term investment, fixed income ETFs are used to provide a counterbalance in times when prices are falling and interest rates are on the rise. The risk however with this assumption is that when interest rates begin to fall again the income generated by these ETFs fall as newer bond derivatives are purchased to replace called and maturing ones. Again, employing a balanced asset allocation approach to fixed income ETF investing provides some hedge against these changes in interest rates and provides a more even and predictable overall return for the investment portfolio.

All portfolios that invest in exchange traded funds should look to have some percentage held in all asset classes as a way to minimize downside risk from any one asset class.