This tutorial will walk you through the filters specific to Fixed Income ETFs you can choose from when screening for Fixed Income ETFs. AlphaBeta ETF identifies four key filters, namely Duration, Bond Issuer, Rating, and Bond Type, as the foundation to look for the right Fixed Income ETF for you.
What are the Fixed Income-specific filters I can use?
Duration: Effective duration is a measure of a bond's price sensitivity to changes in benchmark interest rates, specifically accounting for bonds with embedded options (e.g., callable or putable bonds) where future cash flows are uncertain.
Effective Duration vs Term to Maturity
- Term to maturity is the remaining linear lifespan of a bond, i.e. the exact number of years until the issuer is scheduled to repay the principal. While maturity focuses on when you receive the final payment, effective duration focuses on how much the market price will fluctuate as rates move. Generally, duration is shorter than maturity for any bond that pays coupons because the early interest payments effectively “shorten” the weighted average time until the investor’s capital is returned.
- Duration is a better metric than Term to Maturity to understand how the price of a bond responds to a change in interest rate. For example, the effective duration of a 5-year variable rate bond (floating rate note) is very close to zero, since the bond’s coupon rate automatically adjusts to current market interest rates at predefined intervals (e.g. quarterly). When market rates change, the bond’s next coupon payment changes with them, which stabilizes the bond’s price. The relationship between Effective Duration and price change of bonds is explained in more details below.
Relationship between Effective Duration and Bond Price Change
- Before understanding the relationship between effective duration and price change of bonds, we should first understand Yield to Maturity (YTM). YTM represents the total annual return an investor can expect if a bond is held until its end date and all payments are made as scheduled. It is the internal rate of return (IRR) that equates the current market price with the present value of all future cash flows.
- YTM is the sum of a risk-free rate and a yield spread. Risk-Free Rate is the base return required for an investment with virtually zero risk of default, typically represented by government bonds like U.S. Treasuries. Yield Spread is the additional compensation investors demand over the risk-free rate to account for the risk premium specific to the bond. Major components of the spread include:
- Credit Risk: The danger that the issuer may fail to make scheduled interest or principal payments.
- Liquidity Risk: The difficulty of selling the bond quickly without a significant price discount.
- Call/Option Risk: Compensation for embedded options, such as the issuer’s right to redeem the bond early.
- The relationship between a bond’s duration and its price change is inverse and proportional: for every 1% change in YTM (or market interest rates), the bond’s price is expected to change by approximately the percentage of its duration in the opposite direction. For instance, a bond with a duration of 5 years will experience an approximate 5% price decrease if its YTM rises by 1%, and a 5% price increase if its YTM falls by 1%.
Bond Issuer: A bond issuer is a legal entity that borrows capital from the public or institutional investors by selling debt securities. In this transaction, the issuer acts as the borrower and the bondholder as the lender. The issuer is legally obligated to pay periodic interest (coupons) and return the principal amount on a specified maturity date.
Government
Description: These are national or sovereign governments, such as the U.S. Treasury. They issue bonds to fund public services, national debt, and large-scale infrastructure projects. Because they are backed by the full faith and credit of a nation, these bonds are generally considered the safest investments with the lowest default risk.
Municipal
Description: These include state and local governments, cities, counties, and specialized authorities. They issue municipal bonds to finance local projects like schools, highways, and hospitals. A key feature of municipal bonds is their tax-advantaged status, as interest income is often exempt from federal and sometimes state/local taxes.
Example: iShares National Muni Bond ETF [MUB]
Corporate
Description: These are private or public companies ranging from multinational giants to smaller enterprises. Corporations issue bonds to fund business expansions, acquisitions, or to refinance existing debt. Corporate bonds typically offer higher yields than government bonds to compensate investors for credit risk, which is the greater possibility that a private company might default compared to a sovereign nation.
Rating: A bond rating is a standardized letter grade assigned to a debt security that represents the issuer's creditworthiness and the likelihood of them defaulting on payments. Independent agencies, primarily S&P Global, Moody's, and Fitch, conduct deep financial audits of an issuer's cash flow, debt levels, and management quality to assign these grades.
Investment Grade
Description: These bonds are rated BBB- or higher (by S&P/Fitch) or Baa3 or higher (by Moody’s) and are considered to have a low risk of default. They are typically issued by financially stable corporations and governments.
Example: Vanguard Total Bond Market ETF [BND]
High Yield
Description: Also known as Junk Bonds and are rated BB+ or lower (by S&P/Fitch) or Ba1 or lower (by Moody’s), these bonds carry a higher probability of default and are considered speculative. Because of this increased risk, they must offer higher interest rates to attract investors.
Bond Type: Bond type refers to the specific structure, interest payment method, or underlying collateral of a debt security. Different types allow issuers to customize their borrowing based on market conditions while providing investors with various risk-reward profiles.
Treasury
Description: A Treasury bond is a security issued by a national government, such as the U.S. Treasury. These bonds are widely regarded as virtually risk-free because they are backed by the full faith and credit of the issuing government.
Inflation-Linked
Description: Inflation-linked bonds, such as Treasury Inflation-Protected Securities (TIPS), are debt instruments designed to protect an investor’s purchasing power by indexing the bond’s principal value to a recognized inflation measure like the Consumer Price Index (CPI). As inflation rises, the bond’s principal is adjusted upward, which in turn increases the semiannual interest payments, ensuring the investment’s real value remains stable even as the cost of living increases.
Securitized
Description: They are created through the process of securitization, where individual, often illiquid loans are pooled together and repackaged into interest-bearing securities that can be sold to investors.
Mortgage-Backed
Description: A specific type of asset-backed security where the underlying collateral consists exclusively of a pool of mortgages, typically residential or commercial home loans.
Example: iShares MBS ETF [MBB]
Asset-Backed
Description: These are financial securities collateralized by a pool of non-mortgage assets, such as credit card receivables, auto loans, or student loans.
Example: Virtus Newfleet ABS/MBS ETF [VABS]
Loan-Securtized
Description: Often specifically called Collateralized Loan Obligations (CLO), these are structured securities backed by a diversified pool of corporate loans, usually leveraged loans made to businesses with below-investment-grade ratings.
Example: Janus Henderson AAA CLO ETF [JAAA]
Equity-Linked
Description: These are hybrid securities with both debt and equity features. Common equity-related bonds include Convertible Bonds and Preferred Securities.
Convertible
Description: Convertible bonds pay interest but give holders the option to convert the debt into company stock, offering potential upside if the stock price rises.
Preferred
Description: Preferred securities pay fixed dividends and rank higher than common stock in liquidation, but lower than standard bonds.
How to pick the right combination of the above Fixed Income-specific considerations?
Understanding your exposures
Region, Rating, Duration and Yield: These are intrinsically linked components of a cohesive risk-return profile. The geographic region often dictates the baseline interest rate environment and sovereign risk, which in turn influences the credit ratings of local issuers. Consequently, higher-yielding ETFs typically reflect either a region with elevated inflationary pressures or a portfolio of lower-rated "high-yield" securities that carry greater default risk.
Risk-free rate
- The risk-free rate is primarily determined by the region in which the ETF invests, as it is typically tied to the yield of a sovereign government’s default-free debt, such as the U.S. Treasuries. This rate reflects the region’s specific economic conditions, including its inflation expectations and central bank policies. Because the risk-free rate acts as the baseline for all other local securities, changes in a region’s sovereign health can shift the entire yield environment for ETFs focused on that area.
- The risk-free yield curve shape serves as a visual representation of the relationship between yield and time, with its slope fundamentally driven by investor expectations of future interest rates and economic health. An upslope (or normal) curve occurs when longer-maturity bonds offer higher yields than shorter-term ones, as investors demand a “term premium” to compensate for the greater uncertainty and inflation risk associated with locking away capital for extended periods. Conversely, a downslope (or inverted) curve arises when short-term yields exceed long-term yields, signaling that the market expects interest rates to fall in the future, often due to an anticipated economic slowdown or recession. This inversion typically reflects a scenario where central banks have raised short-term rates to combat inflation.
Spread
- The spread represents the additional yield required by investors to compensate for the credit rating and perceived default risk of an issuer relative to the risk-free benchmark. Higher-rated bonds issued by corporates or non-U.S. (especially Emerging markets) sovereigns command narrower spreads versus U.S. treasury, while lower-rated high-yield bonds offer wider spreads to attract capital.
- During periods of economic instability in a specific region, spreads often widen as investors demand more compensation for the increased risk of downgrades or defaults.
Risk appetite and Macroeconomic conditions
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Risk Appetite: Risk appetite fundamentally shapes fixed income ETF allocation by determining the acceptable trade-off between capital preservation and yield maximization. Conservative investors typically favor established regions like the U.S. or EU and bonds with high-quality credit ratings (AAA to A) to ensure stability, while maintaining short duration to insulate their principal from interest rate volatility. In contrast, aggressive investors often move down the credit spectrum into high-yield or emerging market regions, accepting higher default risks and longer durations to lock in elevated yields and maximize total returns in a declining rate environment.
Macroeconomy and market conditions: Common considerations and comparisons include monetary and fiscal policies of different countries, corporate profitability, and inflation outlook.
Monetary and Fiscal Policies
Monetary policy, specifically the setting of short-term interest rates, directly influences the front end of the yield curve, while fiscal policy and government borrowing levels impact long-term rates by adjusting the supply of sovereign debt. When policies are expansionary, risk-free rates may fall, prompting investors to choose ETFs with longer durations to capture price appreciation. Conversely, restrictive policies or high government spending can drive risk-free rates higher, making short-term government bond ETFs more attractive for capital preservation.
Corporate Profitability
Spreads typically tighten as corporate profitability improves and default risks subside, often leading investors toward corporate or high-yield ETFs to capture the premium over risk-free assets. However, as the cycle matures or signals a downturn, spreads tend to widen as market participants become risk-averse. In these conditions, investors often rotate into higher-quality, investment-grade ETFs that offer more resilient spread protection against economic volatility.
Inflation Outlook
Inflation-linked ETFs are designed to protect the purchasing power of an investment by adjusting their principal or interest payments based on changes in a consumer price index. The demand for these instruments depends on the gap between market expectations and actual inflation levels. If the macroeconomy faces sticky inflation or supply-side shocks, nominal bonds may lose real value, making inflation-linked ETFs a preferred choice to hedge against rising prices.