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Fund Watch

5 Best Bond ETFs for Today’s Market

Favor low fees and diversity over exchange-traded funds with extremely long maturities.

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Exchange-traded funds have long been a popular, low-cost way to invest in a wide variety of stocks. Bond ETFs have been slower to catch on, but that is starting to change.

See Also: Our Favorite No-Load Mutual Funds

One reason may have to do with today’s low yields. Although bond ETFs charge an average of 0.32% in annual fees—slightly more than the average of 0.20% for a no-load bond index mutual fund—ETFs are still markedly cheaper than actively managed bond funds. On average, a no-load actively managed bond fund costs 0.68% per year. “When interest rates are low, looking at cost becomes very important because it eats up a big chunk of your yield,” says Thomas Boccellari, an ETF analyst at Morningstar.

But even though bond ETFs are cheap, you must be careful about which funds you invest in today. Like most index funds, bond ETFs passively track a benchmark. But the makeup of that benchmark may not always be favorable. For example, low-yielding U.S. Treasury bonds now account for more than one-third of the Barclays U.S. Aggregate Bond index, which is considered to be the benchmark for the investment-grade, taxable segment of the domestic bond market. That’s nearly double the average holding of Treasury bonds in intermediate-term U.S. bond funds. Once bond yields begin to climb from today’s microscopic levels, losses among ETFs that mimic the Barclays index, often referred to as the AGG, are likely to be significant (bond prices move in the opposite direction of yields).

If you invest in a bond ETF, you’ll want to focus on a few key things. First, continue to look at cost. The lower the fee, the more income you will pocket. That’s particularly important today. And although ETFs generally are cheap, some charge less than others. For example, annual expenses for iShares Core U.S. Aggregate Bond (AGG)—which, not surprisingly, tracks the AGG—are only 0.08%. What’s more, you can buy this ETF at Fidelity and TD Ameritrade without having to pay a brokerage commission.

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The fund’s average duration, a measure of interest-rate sensitivity, is 5.1 years. That suggests that if bond yields were to rise by one percentage point, the fund’s net asset value per share would drop by roughly 5%. The fund, which yields 1.9%, delivered a total return of 5.8% over the past year and 4.0% annualized over the past five years. (Returns and yields are as of December 19.)

To get a bit more yield—at the expense of slightly more interest-rate risk—consider adding an ETF that invests in high-quality corporate bonds. A solid choice is Vanguard Intermediate-Term Corporate Bond (VCIT). It has a 3.1% yield and an average duration of 6.4 years, suggesting that it would lose 6.4% if rates rose by one percentage point. Over the past year, the ETF returned 7.2%, and over the past five years 6.7% annualized. Expenses are just 0.12% per year.

If you’re worried about losses from rising interest rates, Boccellari recommends putting a portion of your bond portfolio in iShares Floating Rate Bond (FLOT). The ETF owns variable-rate, investment-grade bonds that banks issue to companies; the interest rates adjust every quarter. Unlike most “bank loan” funds, though, Floating Rate holds only bonds that have been extended to high-quality companies, so it has less credit risk than a typical bank-loan fund does. Floating Rate Bond yields just 0.4%. But if the Federal Reserve begins to raise short-term interest rates in 2015, as seems likely, you’ll get the full benefit of fatter yields with little risk to your principal. The fund, which launched in 2011, returned a minuscule 0.3% over the past year and 1.8% annualized over the past three. Annual fees are 0.20%.

For more income, tread carefully. Energy companies make up 16% of the high-yield, or “junk,” bond market, according to brokerage LPL Financial. And the precipitous drop in oil prices has raised concerns that some of those firms will eventually default on their debt. As a result, the Bank of America Merrill Lynch U.S. High Yield Master II index, a broad measure of junk bonds, has fallen 3.4% over the past six months. Yields in turn have climbed from a low of 5.2% in June to nearly 7% today. Marilyn Cohen, founder of Envision Capital Management, which specializes in bonds, says high-yield investors should brace for more rough patches. Should losses become too large for you to stomach, you’ll be better off with a large, heavily traded junk bond ETF, which you’ll be able to sell more easily than a small ETF. Our pick: iShares iBoxx $ High Yield Corporate Bond (HYG), the largest junk ETF. The ETF keeps 13% in oil and gas companies—slightly less than the high yield market—and has less exposure than some of its peers to the lowest-rated junk debt, which reduces the risk of losses from defaults. Annual expenses are 0.50%. The fund returned 2.5% over the past year and 7.8% annualized over the past five. It yields 5.6%.

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Finally, if you want to diversify your fixed-income holdings by heading overseas, beware the strong dollar. Most foreign-bond ETFs are denominated in local currencies, Boccellari says. And a robust dollar can eat into those funds’ returns because gains abroad get translated into fewer greenbacks at home. To get around this, consider Vanguard Total International Bond (BNDX). The ETF tracks a broad index of foreign bonds, including a small dose of emerging-markets debt, but uses hedging techniques to minimize the impact of currency swings. Over the past year, International Bond returned 8.3%, better than 95% of global bond ETFs, according to Morningstar. The fund, which started in 2013, yields 1.0% and has an average duration of 7.1 years. Annual fees are 0.20%.