Fuss to investors: Avoid these fixed-income ETFs

Dan Fuss, portfolio manager of the $20 billion Loomis Sayles Bond Fund Ticker:(LSBRX), says market-cap-weighted ETFs make sense — just not when it comes to fixed income.

Investing in an equity index, such as the S&P 500, makes sense because over a long period of time the index has a positive bias toward companies with rising market capitalizations, Mr. Fuss said. “In general, with equities, low turnover and low costs lead to better returns over a long time period,” he said.

But when fixed-income exchange-traded funds are weighted by market cap — and most of them are — they are simply giving the largest weighting to the company that issues the most debt.

“It’s the biggest borrowers I’m supposed to give money too? Who’s supposed to go broke here?” he asked.

Fixed-income ETFs have taken off. In the past 12 months, total assets in fixed-income ETFs have risen to around $200 billion. That’s nearly a 38% increase.

Fixed-income ETFs in illiquid markets, such as high-yield bonds, give Mr. Fuss the most concern. Not because of the products themselves, he noted, but because of the way investors use them. “There’s this push, push, push for yield going on right now,” he said.

In the high-yield market, returns generally are driven by investor money coming in or going out. If there are large inflows, the funds tend to perform well. When investors start pulling money out, however, the ETFs (and traditional mutual funds for that matter) can be forced to sell to meet the redemptions. In extreme cases, such as the financial crisis of 2008, fund managers end up trying to sell into an illiquid market. That, in turn, creates disruptions in prices and steep losses, Mr. Fuss said.

Closed-end funds, which have a fixed number of shares that trade intraday on an exchange, are the best suited to take advantage of those disruptions because they don’t have to worry about redemptions, Mr. Fuss said. “That’s when they get to buy at their price,” he said. “They can clean up and take advantage.”

Overall, Mr. Fuss isn’t particularly bullish on the U.S. fixed-income market, whether it’s in ETFs or not.

“There might be individual spots here and there, but there are fewer now than there have been in a very, very, long time,” Mr. Fuss said.

The reason? The Treasury Department has artificially supported the bond market, driving yields low, thanks to having its own central bank and “overseas friends” who are willing to buy the government’s debt at its low yields.

The 10-year Treasury was trading at less than 2% today, but Mr. Fuss says that without the government’s support it would be realistically trading at around 4%. With that in mind, the 3% average yield on corporate bonds doesn’t look so good, he said.

To find the best value, Mr. Fuss is looking at developed and emerging foreign markets with favorable interest rates and currency environments.