by Cynthia Harrington, CFA

The long-awaited fixed-income exchange traded funds (ETFs) arrived in late July. Barclays Global Investors launched four series of bond ETFs by offering investors many of the same advantages as their equity counterparts.

Rick Adkins, CFP, ChFC and chief executive of Arkansas Financial Group, in Little Rock, Ark., claims one place for the new product at their firm. "These funds could have the biggest advantage for a client with half their $200,000 portfolio in bonds," he said. "At that level of investment it is hard to find proper diversification at such low cost."

The four new funds sport rock bottom expense ratios of 0.15 percent. Compared to traditional open-end bond funds and closed-end funds, the new BGI iShares reward more of the returns to the investors.

Low cost and diversification for smaller portfolios top the list of advantages but the list is long. Shares are listed so can be hedged. The new funds offer transparency of holdings and intra-day pricing. "Unlike stocks where prices are widely disseminated, the fair market value of bonds that trade on the secondary market is difficult for individual investors to access," says Lee Kranefuss, chief executive of BGI’s Individual Investor Business.

The four new funds enter a popular area of investing. ETFs exploded to $88 billion in assets since their introduction in the mid-1990s. Advisors prefer ETFs to traditional open-ended funds because of the ease of buying the shares on an exchange and the lack of spread between the net asset value and the market price.

Three funds are pegged to Lehman Treasury Bond Fund indexes: the one-to-three year, the seven-to-10 year and the 20-plus year. The fourth offering is a corporate bond fund based on Goldman Sachs GS $ InvesTop’ index.

Advisors have obvious concerns about the new product. Benjamin Tobias, CFP, CPA, CIMA, of Tobias Financial Advisors, in Ft. Lauderdale, Fla., who calls ETFs, "God’s gift to advisors," is reserving action until he completes the training seminar in November, in Chicago. Tobias’ main concern is the liquidity of the bonds and the trading platform. "The reason why equity ETFs work is the institutional support to provide liquidity to funds," said Tobias. "Buying bonds is not like buying stocks. The difference between a consistently good bond manager and lesser competitors is often the trading capabilities and the trading platforms of the good managers."

Liquidity concerns rest on the corporate bond offering, but not the treasury funds. Some of the concerns for liquidity are answered in the makeup of the underlying index. Goldman Sachs’ GS $ InvesTop Corporate Bond index includes a basket of 100 corporate bonds. All bonds are listed and have a face value above $500 million. To be included, the issue must achieve a high liquidity score, which is based on the size of the issue still outstanding, as well as the length of time from issue and time left to maturity. The index is rebalanced monthly based on objective specified criteria.

Adkins counts on the existing liquidity in the listed corporate bond market to apply to the new funds. He and his colleagues trade bonds differently than institutional investors. "It’s a trickier trade to do three $50,000 bonds than to do three $1 million bonds," he explained. "From a practical standpoint, if we have a client that needs to sell, we find a client that needs that bond to buy it. We split the spread and save both money."

"But keep in mind you can always sell the bond, you just can’t always get your price," he added.

Adkins uses equity ETFs for many classes and many investors. They use the iShares in the mid-cap class and SPDRs and DIAMONDs in others. Asset allocation drives the process. Once the model is run, they go looking for investments that satisfy the allocation requirements, as well as match the client’s unique needs.

Fitting the new products into the allocation model presents the challenge to Adkins. "The problem that arises with these funds is how to classify them," he said. "I suppose we could use our one-to-10-year index, then figure the short and intermediate classes separately, and to back and add them together."

BGI acknowledged the problem of fitting the new products into existing allocation procedures. "Investor interest in fixed-income exposure has been very high, but determining the best allocation for an individual’s portfolio can be challenging," said Mark Chamberlain, strategist in BGI’s Individual Investor Business.

One solution offered by BGI is an iShares’ Core/Satellite tool, which allows advisors to run a series of index and active management "what-ifs" for their clients. The tool can be accessed on the iShares Web site. It now includes historical data on the four fixed-income indices that comprise iShares’ new bond ETFs.

Nor do the concerns stop at liquidity and fitting into existing allocation planning. Advisors are understandably skittish about credit ratings on bonds after the near-total disasters in companies like Enron and WorldCom. "If they’re only rebalancing monthly they might end up riding bonds down after the credit rating drops," said Adkins. "Think of all the bonds over the last couple of years with a nice AA credit rating that fell to junk, and quickly."

According to Goldman Sachs, bonds must be rated at least BBB- by S&P or Baa3 by Moody’s to qualify. Split-rated (e.g., Baa3/BB+ or Ba1/BBB) issues are excluded from the index. The monthly rebalancing is designed to eliminate bonds with deteriorating credit. That means a bond with a credit rating lower than the required initial rating stays in the index no more than 30 days after the rating drops.

Apart from the structures of the new offerings, investment strategy may affect their success. "It’s difficult to think about buying bonds at all right now. It’s scary because interest rates are so low," says Tobias. "It may be the time to be in actively traded funds, if any. Bond money managers that are thinking that rates are going up in the next 12 to 24 months can switch to lowest duration issues. That’s not available in a fixed index."

More fixed-income ETFs are sure to follow - BGI filed three more funds with the Securities and Exchange Commission and ETF Adviser also has funds in registration. After the overwhelming success of equity ETFs, the investment community is watching carefully to see if the fixed-income funds catch fire in the same way. With the slate of new offerings, the answer should be known soon.

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