investing

Adding Caution to the Kiplinger ETF 20

We've traded VanEck Vectors Fallen Angels High Yield for iShares Ultra Short-Term Bond to tamp down risk among our favorite exchange-traded funds.

As the specter of an economic slowdown and eventual recession looms, we’re making a defensive shift in our Kiplinger ETF 20 roster (the collection of our favorite exchange-traded funds for a well-rounded portfolio), swapping VanEck Vectors Fallen Angels High Yield (ANGL for iShares Ultra Short-Term Bond ETF (ICSH).

Vectors Fallen Angels High Yield holds bonds issued by firms that once fetched investment-grade credit ratings but have since “fallen” to lower-rated “junk” status because of weak balance sheets, poor management or other troubles. (Junk bonds have a greater risk of default compared with investment-grade debt.) In other words, the ETF invests in bonds the credit-rating agencies once regarded as safe but now consider speculative.

In good times, Vectors Fallen Angels High Yield soared. It returned 25.7% in 2016 and 9.4% in 2017, beating most of its peers in both years. But over the past year, the fund has lost 2.7%, trailing 94% of its high-yield ETF peers. Indeed, if the economy has seen its best days (for the current cycle), a move to higher-quality bonds is prudent. “Given where we are in the current market, it’s a good idea to build into your bond portfolio some resiliency, more diversification and more high-quality debt,” says Jonathan Rather, a member of the fixed-income strategy team at investment firm BlackRock.

That brings us to iShares Ultra Short-Term Bond, an actively managed fund that offers a mix of high-quality bonds with one- to three-year maturities. Roughly 82% of the port­folio—a mix of short-term corporate notes, investment-grade floating-rate bonds and some certificates of deposit—is rated single-A or better. (Investment-grade ratings start at triple-B and go up to triple-A.) What’s more, the fund has a low, 0.39-year duration (a measure of interest-rate sensitivity). That means if rates were to rise by one percentage point, the fund’s net asset value would fall 0.39% (yields and prices move in opposite directions). The broad bond market index, Bloomberg Barclays U.S. Aggregate Bond, has a duration of nearly six years.

The iShares fund has recently shown how resilient it can be. Over the past 12 months, as the Agg index struggled to stay in positive territory, Ultra Short-Term Bond gained 2.3%. The ETF even beat the 1.6% return of Pimco Enhanced Low Duration Active (LDUR), a Kip 20 ETF we added last year as a hedge against rising interest rates.

What’s the difference between iShares Ultra Short-Term Bond and Pimco Enhanced Low Duration? An investment in either would be considered a defensive move, but the iShares ETF portfolio is an even more cautious play, thanks to its higher-quality portfolio. Ultra Short-Term holds only investment-grade debt; 10% of the Pimco fund is junk-rated or unrated. The trade-off, of course, is yield. The Pimco ETF yields 3.7%; the iShares offering, 3.0%. We think there’s room for both in your portfolio.

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