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We Built A Better Bond Basket

We are re-optimizing our portfolio and improving the bond basket. Take a look at what's inside the new bond portfolio.

Articles by Dan Egan

By Dan Egan
Managing Director of Behavioral Finance & Investing, Betterment  |  Published: September 6, 2013

Our new bond basket increases both diversification and the ability to manage risk.

We have added international bonds with no exchange rate risk.

Allocations are optimized at each risk level.

This fall we are re-optimizing our portfolio and have been blogging about the benefits for our customers. In a related post, we explained how the new portfolio mix is likely to boost expected returns overall at every level risk. In this post, we’re taking a closer look at each of the new bond ETFs we are adding to our optimized portfolio.

Bonds are key for managing risk and creating an alternative source of returns to stocks alone.

As with every investment we include in Betterment’s portfolio, our investing experts adhere to certain criteria to ensure we’re delivering the optimum performance at the lowest cost. We don’t believe in active management, so every investment must track an index. We only choose ETFs that are broad-based, suitable for the long term, and have a low expense ratio.

Given our baseline selection criteria, here are the ETFs that comprise our new bond basket. There is no longer a set distribution percentage for each ETF across the bond basket. Rather, the distribution is based on the overall stock-to-bond allocation.

 Here are the key characteristics of our new bond ETFs:

Short-Term Treasuries (SHV): One of the key ways to control risk in a portfolio is to have at least one asset which is as low-risk as possible in the basket — such as a very high-quality, short-duration set of bonds which has almost zero risk and is liquid (unlike, say, a certificate of deposit). In the old portfolio, this role was played by SHY. Now we will be using SHV, an iShares ETF made up entirely of even shorter term treasuries, with an average maturity of five months. This is similar to what a money-market fund holds.

Short-Term Inflation-Protected Bonds (VTIP): The only other bond ETF in the prior portfolio was an inflation-protected bond fund (TIP). Now that we are diversifying the basket more broadly, we can hedge against inflation risk with more precision. VTIP is a fund very similar to TIP, except that it tracks shorter-term bonds, which means that it tracks inflation more closely than TIP.

High-Quality U.S. Bonds (AGG): High-quality U.S. bonds represent a large part of global capital markets. They are issued primarily by the government and other highly rated issuers, and tend to have very low default rates. The broad nature of the index that tracks these bonds means they have higher yields, but also more interest rate risk. We selected AGG based on its very low expense ratio (just 0.08%), and high liquidity.

Corporate Bonds (LQD): Corporate bonds typically have higher returns but a higher risk, because the companies issuing the bonds have a slightly higher credit risk (i.e. risk of default) than a government bond. The issuers tend to be corporations that are financing projects or short-term needs with debt rather than equity. 

High-Quality International Bonds (BNDX): The high-quality non-U.S. bond market is similar in size to the overall U.S. market, but offers significant diversification of risk. A diversified basket of British, European, Japanese bonds, and bonds from other countries have their own specific and independent risk factors. One concern when investing in international bonds is the exchange-rate risk. We have selected a newer Vanguard ETF, BNDX, as our high-quality international bond offering, which hedges out all exchange-rate risk.

Emerging Markets Bonds (VWOB): Emerging markets bonds — lending to support infrastructure projects and governments in developing markets — tend to be more volatile, with movements more characteristic of a stock rather than a bond. That means they do an excellent job diversifying our bond basket, but are less appropriate at lower risk levels and we use them sparingly in the overall portfolio. We have chosen VWOB for our Emerging Markets bond instrument. Like BNDX, we are not taking on any exchange-rate risk in our Emerging Markets bonds, as they are denominated in U.S. dollars.

Managing Risk Better

While all portfolios benefit from these additions, low-risk goals, which are more vulnerable to volatility, will see a particular benefit for two reasons. 

First, we are reducing the average maturity of the bond basket for low-risk goals, by replacing the existing bond ETFs, SHY and TIP, with SHV and VTIP. Generally, the shorter the maturity of a bond, the less sensitive it is to interest-rate changes.

Second, we have also diversified away from U.S.-only bonds. For example, if you hold 70 percent bonds, a third of your bond basket will now be international bonds (with no foreign exchange-rate risk). International bonds are still somewhat responsive to U.S. interest rates, but that movement should be dampened significantly compared to a U.S.-only bond basket.

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