When Bond ETPs Don’t Make Distributions (ITLY, LBND, TLT, EDV)

Michael Johnston:  Assets in bond exchange-traded products have been climbing steadily for the past several years, reflecting an increased degree of comfort among investors with the idea of achieving fixed income exposure through the exchange-traded wrapper. The bond ETF universe has expanded quite a bit in recent years; there are now exchange-traded products that cover most major international bond markets, as well as several funds that offer very precise duration exposure in multiple segments of the U.S. market [see Bond ETFs For Every Objective].

Another innovation has been the development of products that offer exposure to fixed income not by holding bonds, but by replicating indexes comprised of futures contracts with various bonds as the underlying. While these products may appear to be similar to “traditional” bond ETFs on the surface, they can be very unique in several significant ways. It may surprise investors to learn that many bond ETPs never make distributions–not because of the lack of yields in the related asset classes, but because of the nuances related to the manner in which they deliver the exposure offered.

A growing number of bond ETNs replicate indexes comprised not of bonds, but of futures contracts linked to bonds. While this approach can allow for low cost exposure to certain asset classes, it also generally means that the related exchange-traded products won’t make distributions. Because the underlying futures contracts don’t actually make coupon payments, there is nothing for the ETP to pay out to investors [see also Five Things We Learned At Inside ETFs].

This feature isn’t necessarily a negative, but should obviously be considered when evaluating the various options. Below are profiles of two ETNs that offer access to high-yielding corners of the bond market but will never make a distribution to shareholders [for more ETF insights, sign up for the free ETFdb newsletter]:

PowerShares DB Italian Treasury Bond Futures ETN (NYSEArca:ITLY)

This ETN has become a barometer for the level of anxiety over the European debt crisis, as ITLY is the only exchange-traded product focusing on Italian sovereign debt. This ETN is linked to an index consisting of Euro-BTP futures contracts that have debt issued by the Italian government as the underlying assets. Specifically, the underlying securities have a remaining term to maturity of about ten years.

Yields on Italian bonds have jumped back and forth in recent weeks, spiking when concerns about Europe increase and pulling back when investors grow more optimistic that the continent can avoid a wave of defaults [see Euro Free Europe ETFdb Portfolio ]. Though ten-year Italian bonds are now yielding about 5.5%–down quite a bit from recent highs–ITLY has not made a distribution since its inception in March 2011 and likely won’t do so any time in the foreseeable future. Still, ITLY has turned in some impressive results in 2012; this ETN is already up about 15% on the year.

3x Long 25+ Year Treasury Bond ETN (NYSEArca:LBND)

Long-term bonds have been on a hot streak for the last several years, delivering some impressive gains as concerns about pending rate hikes eased and interest in high-yielding securities surged. LBND, which offers monthly leveraged exposure to long-term bonds, has been one of the best performers from the entire ETP universe; this ETN has more than doubled over the last year.

Part of the appeal of long-term bonds lies in the meaty distribution yields offered; the Barclays 20 Year Treasury Bond Fund (NYSEArca:TLT) has a 12 month yield of about 3.4%, while the Vanguard Extended Duration Treasury ETF (NYSEArca:EDV) has a 30-day SEC yield of about 3.2%. So leveraging up those distribution yields may seem like an opportunity to get effective payouts close to double digits–a level that is hard to come by in this environment [see Bond ETFs That Steer Clear Of Interest Rate Risk]. But that’s not in LBND’s job description–in fact, this ETN has never made a distribution. The underlying index consists of Ultra T-Bond futures, contracts traded on the CBOT whose underlying assets are U.S. Treasury Bonds with a remaining term to maturity of at least 25 years. Although LBND will perform well when long-term bonds climb, it will never make a meaningful distribution.

Buyer Beware…

The fact that these ETPs don’t make distributions certainly doesn’t make them flawed products; there are both advantages and drawbacks to a futures-based approach to bond exposure, and in many cases these products represent the only way to tap into these corners of the global fixed income market. But the lack of distributions is certainly worth noting, especially for investors who manage their fixed income portfolio with the goal of maximizing current yield [see High Yield ETFdb Portfolio ].

It should also be noted that the above ETNs are in no way misleading; both are pretty clear about the fact that they generally won’t make distribution payments. But for investors who fail to do a bit of research into potential positions, the lack of payouts could potentially come as an unwanted surprise. Take a few minutes to review any potential bond ETP investments to determine how they deliver the desired exposure. If futures contracts are involved, distributions are probably pretty unlikely.

Written By Michael Johnston From ETF Database  Disclosure: No positions at time of writing.

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