Bond ETFs: how to build a conservative portfolio in dollars

Money held in a strong currency should not simply sit idle in a bank or brokerage account. The global bond ETF market makes it possible to build a portfolio for almost any conservative objective. There is no need to select bonds individually, monitor dozens of issuers, or regularly reinvest coupons: a single fund may hold hundreds or even thousands of issues. Let us look at how this market works, which funds fit which goals, and why a portfolio of ETFs is often more rational than idle dollars or a small collection of individual bonds.

Dollars abroad: three typical scenarios

A common situation in practice: a client opens an account with a foreign bank, transfers rubles, converts them into dollars — and stops there. The money simply sits in the account, earning nothing while its purchasing power gradually declines. For some reason, this still feels reassuring: after all, the money is abroad and held in a strong currency.

The second option is essentially the same, only in a brokerage account. Some brokers do pay interest on idle cash balances. At the current US policy rate, that comes to around 3.5% per year. SIPC — roughly analogous to Russia’s deposit insurance system, but for brokerage accounts — protects up to $250,000 in cash, while client balances are often significantly larger. The broker may be reliable, but risk is still risk.

The third scenario: a foreign broker offers clients who do not want to trade actively its own bonds yielding 7–8% per year in US dollars. Attractive numbers and assurances of reliability can be persuasive. But yield does not come from nowhere. If a company has to borrow at roughly twice the government’s cost of funding, it means lenders are not willing to provide money more cheaply. That is a sign of elevated credit risk. In effect, the investor takes a concentrated, unsecured credit position. To be fair, there have been no problems so far. But if something does go wrong, there is only one place to go — the back of a long line of creditors.

Buying a bond ETF does not eliminate infrastructure risk. But instead of an unsecured claim on a single financial company, the investor owns a diversified portfolio of securities. Those assets are held separately from the broker’s own property. As a rule, if an intermediary ceases operations, the securities can eventually be transferred to another market participant.

Why individual bonds are not always better than a fund

At first glance, an individual bond may seem easier to understand than an ETF: the issuer, coupon, maturity date, and repayment amount are all known. But that apparent simplicity can be misleading.

Across a significant part of the international bond market, the minimum lot size is $100,000–$200,000. The market has historically been geared toward large institutions: banks, insurance companies, and pension funds. For them, $200,000 is small change; for a private investor, it can represent a substantial share of the portfolio. With $2 million of investment capital, for example, a minimum lot of that size would account for 5–10% of the portfolio, limiting the investor to roughly 10–20 issues.

Some corporate and government bonds in the domestic US market are available in much smaller lots — sometimes starting at $1,000.

But even with a small nominal amount, one still has to deal with:

• limited liquidity in individual issues

• wider bid-ask spreads on odd lots

• less favorable execution than institutional investors receive

• the need to analyze each issuer in depth

• the need to regularly reinvest coupon payments and proceeds from partial or full redemptions

• the need to periodically monitor each issuer’s financial condition, covenant compliance, and ratings

• dealing with restructuring in the event of default

According to estimates from the US Securities and Exchange Commission (SEC), execution costs on small trades in corporate and municipal bonds may reach 0.8–0.9%. In some studies , the difference between purchase prices and subsequent sale prices reached 0.85–2.35%. If the expected excess return from security selection is around 1% per year, a significant portion may be “eaten up” by transaction costs before the investment has even had a chance to perform.

Default is a serious risk. If a portfolio consists of 10 equally weighted positions and one issuer runs into trouble, recovering 30–40% of face value may be a very good outcome. A more diversified portfolio reduces the risk to some extent — although several positions may belong to the same sector, industry, or country and suffer at the same time — but realistically, few private investors can continuously monitor developments across more than 20–30 issuers. There are only so many hours in the day.

For a bond strategy earning 4–6% per year, losses of this magnitude are significant. A formal default is often only the beginning of the process: trading may be suspended, followed by a lengthy restructuring that can require investors to collect and submit various documents in the prescribed form. If the position can be closed before an official default, receiving even 30–50% of face value immediately may be preferable to spending months in a creditors’ queue.

Of course, rigorous analysis helps reduce risk, and there are professionals who study issuers every day in search of undervalued bonds. But first, an ordinary private investor and an experienced bond-market professional are still in very different weight classes. Second, according to SPIVA and Morningstar , successful active funds outperform index funds by an average of only 0.2–0.7% per year. Over a 10-year horizon, only about 40% of funds are successful.

What a bond ETF provides

A bond ETF is a ready-made portfolio whose shares are bought and sold on an exchange just like ordinary stocks. Diversification can be extremely broad: a single fund may hold thousands of securities.

Building a comparable portfolio independently would be extremely difficult: it could require tens or hundreds of millions of dollars, sophisticated operating infrastructure, and a team of analysts.

The fund manager handles a number of practical tasks:

• allocates the fund’s assets across numerous issuers

• maintains the target structure by maturity and credit quality

• receives coupons and redemption proceeds and reinvests them promptly, unless the fund distributes current income

• promptly replaces securities that leave the portfolio for one reason or another

• participates in corporate actions and restructurings

An ETF does not make bonds risk-free. A fund’s value may fall because of rising interest rates, widening credit spreads, defaults, and other factors. During the 2020 crisis, for example, some bond ETFs traded at substantial discounts to NAV. Their exchange prices reflected market conditions faster than model-based or stale quotes on illiquid bonds held in the portfolios.

A fund does not guarantee capital preservation. But it is a convenient and transparent wrapper. The investor’s workload and concentration risk are greatly reduced, while costs are generally very low.

Not just “bonds” — dozens of different markets

Today, more than 700 bond ETFs trade in the US market, so choosing among them is not easy. Broadly speaking, the funds can be grouped by issuer type, credit quality, and other characteristics.

Money market and short-term government bonds

This group includes funds investing in:

• US Treasury bills

• government bonds with durations of up to one year

• floating-rate Treasury securities

• ultrashort bonds

• certain money market funds

Their primary role is to provide liquidity with minimal sensitivity to changes in interest rates.

This is probably the closest alternative to holding idle dollars in an account.

Pay close attention to the holdings: a short-term government bond fund and an ultrashort corporate bond fund may show similar historical volatility while carrying fundamentally different credit risk.

Government bonds and agency securities

US Treasury ETFs span almost the entire duration spectrum — from several weeks to 20–30 years — including dedicated zero-coupon bond funds. The pattern is simple: the longer the duration, the more sensitive the price is to changes in interest rates.

Funds holding government agency securities and agency mortgage-backed bonds form a separate category. Their credit quality is close to that of government bonds, but they carry additional risks — most notably mortgage prepayment risk when interest rates decline.

Corporate bonds

The corporate bond segment includes:

• short-, intermediate-, and long-term investment-grade corporate bonds

• high-yield (“junk”) bonds

• bank loans

• floating-rate securities

• convertible bonds

• preferred shares (sometimes loosely grouped with fixed-income instruments because of their “bond-like” features)

• tranches of collateralized loan obligations (CLOs)

Higher yields in this segment compensate investors for taking additional risk. At the time of writing, yield to maturity ranged from 4.7% per year for broadly diversified investment-grade corporate bond funds to 7% per year for high-yield corporate bond funds, with the federal funds rate at 3.5–3.75%.

It is worth remembering that by buying high-yield bonds, an investor is financing companies with weaker balance sheets and a higher probability of default. In a crisis, these bonds can behave much like equities, which makes them inappropriate for a financial safety net .

Inflation-linked and floating-rate bonds

The principal value of Treasury inflation-protected securities (TIPS) is adjusted in line with the US consumer price index. But, perhaps surprisingly, that does not guarantee that TIPS prices will rise during periods of high inflation: if real interest rates rise at the same time, TIPS, like other bonds, can fall in price — as happened in 2022.

Floating-rate bonds are less sensitive to changes in interest rates. Credit risk, however, remains: a corporate borrower can run into trouble regardless of how its coupon is set.

Municipal, international, and specialized funds

The US municipal bond market is also highly developed. The main fund categories include:

• national funds and funds of bonds issued by individual states

• short-term and long-term muni funds

• high-yield municipal bond funds

• Build America bond funds

• target-maturity municipal bond funds

For US investors, municipal bonds can be attractive because some of the income is exempt from federal tax and, in certain cases, state tax as well. For a foreign investor, that tax benefit may have little practical value, while the interest-rate and credit risks remain.

International bond funds may include:

• government bonds of developed countries

• debt of emerging-market governments in US dollars (Eurobonds)

• corporate debt in local currencies, with or without hedging

The fact that an ETF trades in US dollars does not eliminate currency risk. A fund holding bonds denominated in Mexican pesos or Brazilian reais, for example, may trade on a US exchange and be quoted in dollars, but without currency hedging the investor’s final return will still depend on movements in the underlying exchange rates.

Target-maturity funds

A special category consists of ETFs that are designed to terminate in a specific year. A fund may, for example, hold corporate bonds maturing in 2029. As the securities mature, the fund is liquidated and the proceeds are distributed to investors.

These funds sit somewhere between an individual bond and a traditional perpetual ETF. Like an individual bond, their duration gradually declines as the target date approaches. Unlike a single bond, however, the fund may hold securities from hundreds of issuers.

The fund does not guarantee repayment at face value: at the end, the investor receives the actual net asset value attributable to the shares held, which depends on factors such as fees, early redemptions, and defaults.

These funds can also be used to build a “ladder”: capital is spread across ETFs with different target dates, allowing part of the portfolio to mature each year.

Duration: a parameter that cannot be ignored

Bonds are often thought of as a calm asset class. Yet in 2022, investors in long-duration bond funds experienced significant volatility: a supposedly “conservative” portfolio could lose 15–30% of its value. The reason was duration.

Put simply, duration indicates how sensitive the price of a bond or bond fund is to changes in interest rates. If a fund has a duration of 8 years, for example, a 1 percentage point rise in market yields may lead to a price decline of roughly 8%; if yields fall, the effect works in the opposite direction.

Maturity and duration are not the same thing. At maturity, the issuer is expected to repay principal. Duration, by contrast, reflects the timing of all future cash flows and how sensitive their present value is to changes in interest rates.

In practice, the following classification is useful:

The last two categories are often misunderstood. A zero-duration fund does not hold bonds whose prices somehow remain constant. It usually hedges interest-rate risk using futures, swaps, or short positions. Even then, the following risks and costs remain:

• credit risk

• hedging costs

• basis risk between the underlying assets and the derivatives used for hedging

• counterparty risk

• the need to rebalance hedge positions regularly

A negative-duration fund is even more specialized: in theory, its price should rise as interest rates increase. This is a tactical strategy, not a substitute for a bank account or Treasury bills.

When choosing a fund, start with the investment horizon rather than the yield. If the money will be needed in six months, buying long-duration bonds makes little sense even if their current yield looks attractive. Conversely, with a ten-year horizon, minimizing duration is not always sensible: if rates fall, long-duration bonds may appreciate significantly.

What your bond portfolio might look like

There is no single correct bond portfolio: its structure depends on the objective, investment horizon, currency of future expenses, and acceptable drawdown. Below are several illustrative examples. They are neither individual recommendations nor ready-made model portfolios.

How to choose a bond ETF

Fund selection should not begin with a comparison of five-year returns. A top-performing fund may have benefited from long duration during a period of falling rates, or from a larger allocation to lower-quality borrowers during favorable economic conditions. In the next phase of the market cycle, those same characteristics may become disadvantages.

For a consistent assessment, it is worth checking seven key parameters:

1. Objective. What is the fund meant to do: provide a financial safety net, temporarily park cash, protect against inflation, or provide exposure to falling rates?
2. Duration. Does the fund’s sensitivity to interest-rate changes match the time remaining until the financial goal?
3. Credit quality. Who are the borrowers, and how likely are they to meet their obligations?
4. Currency. In which currency are the bonds denominated? Does the fund use currency hedging?
5. Features. Is the fund passive or active? Perpetual or target-maturity? Does it use derivatives?
6. Cost and liquidity. What is the expense ratio? How wide is the bid-ask spread? What is the trading volume, and how far can the market price deviate from net asset value?
7. Taxes and legal structure. Where is the fund domiciled, and what tax and legal consequences does that create for the investor?

A bond ETF is not a universal product that can simultaneously guarantee high returns, no drawdowns, and complete safety. But funds do solve a number of practical problems.

The investor gets:

• instead of an idle dollar balance — a portfolio of income-producing assets

• instead of exposure to the debt of a single financial company — obligations from hundreds or thousands of issuers across different countries, sectors, and industries

• instead of a dozen individual bonds, where one default can wipe out a year’s return — broad diversification

• instead of constantly monitoring coupons, redemptions, and individual transactions — a handful of understandable funds, each serving a specific purpose

For very large portfolios, holding individual bonds may be justified: scale makes it possible to employ a professional team of analysts, spread risk across hundreds of issuers, and turn even a small amount of excess return into a meaningful dollar amount.

For most private investors with several million dollars or less, funds are a more rational starting point.

The sequence matters. First, clearly define the objective, investment horizon, currency, and acceptable level of risk. Then fill the resulting structure with the appropriate “building blocks,” ranging from Treasury bills with durations of a few months to long-term corporate, mortgage-backed, international, and inflation-linked bonds. There are plenty of options.