Bond Ladder ETFs are providing a unique solution for managing duration risk. These ETFs, now available for the municipal, corporate and high yield sectors, enable more precise control over duration risk than previous fixed income ETF offerings. Moreover, they have performance benefits relative to traditional fixed income index funds and ETFs if the rising rate and steep slope yield curve environment persists.
In addition to delaying the onset of tapering, the September FOMC (Federal Open Market Committee) meeting and communications have clarified the timing of any future hikes of the Federal Funds rate. The message is clear – we should remain at nearly zero for an extended period of time, perhaps years.
Absent any potential data-dependent alterations, the short end of the taxable yield curve should remain anchored. Therefore, most bond market yield curves should remain steeply sloped. Returns to taking on additional duration risk should remain elevated. But, as we’ve learned since last July (and in 1994 and 2004), long rates accelerating higher can prove immensely damaging to principal. Taking on additional duration risk from holding longer maturity debt can be risky.
This environment emphasizes that investors need to make suitable and precise choices for duration risk. Unfortunately, most bond market index funds and ETFs attempt to match duration to a bond index. In a rising interest rate environment, these funds have to continually add duration (longer bonds) in order to match their benchmark duration and replace expiring or called shorter issues.
Unfortunately, the bonds they add to the index are also the bonds where the duration risk is concentrated. These funds cannot “roll down the curve”, or capture the duration risk premium as average maturities decline with time.