Federal Open Market Committee (FOMC) meeting minutes released earlier this week paint a picture of a Federal Reserve still committed to raising interest rates, most likely short-term rates, later this year, but also a Fed that can be patient in doing so.
Fixed income investors should remember that the FOMC’s membership is changing and those changes could make for a more dovish Fed. Interest rate hawks Charles Plosser, Richard Fisher and Loretta Mester are departing the FOMC and will be replaced Charles Evans, Dennis Lockhart and John Williams. The latter trio is known for their dovish views.
“If a more dovish Fed takes a slower, steadier approach to tightening than anticipated, fixed investments with longer average durations may not be the portfolio-killers they might otherwise be in an environment where the interest rate rises more rapidly. In fact, peppering portfolios with some exposure to longer duration may offer an opportunity for enhanced yield and total return, as well as diversification from equity risk,” according to a recent research note by Invesco PowerShares, the fourth-largest U.S. ETF issuer.
Said another way, the longer the Fed waits to raise interest rates, even though it is short-term rates that are likely to be raised first, the more attractive longer duration bond ETFs become. That theme was on display last year and has been renewed again in 2015 as highlighted by the returns offered by some of the top-performing bond ETFs. [Bond ETF Stars of 2015]
Build America Bond ETFs, including the owerShares Build America Bond Portfolio (NYSEArca: BAB), are beneficiaries of falling Treasury yields and a patient Fed. BAB, which had a duration of about nine years at the end of 2014, climbed 17% last year and is already up 3% in 2015.
Potential investors, though, should be aware that municipalities have stopped issuing new Build America Bonds after the program ended in 2011. Consequently, when rates rise, the fund would not be able to buy new issuance with higher interest rates to offset principal losses from its underlying holdings. Amid a favorable interest rate environment, investors have added $123.5 million to BAB over the past year. [Interest Rate Risk With Bond ETFs]
“A more dovish Fed favoring low interest rate— combined with indications of global economic slowdown and falling asset prices — may translate into a more benign rate environment for 2015 than expected. With this in mind, investors may want to reconsider stripping away all interest rate exposure from their income allocation and instead consider a more diversified and balanced maturity structure,” adds PowerShares.
Another longer duration idea that could thrive if the Fed continues waiting to hike rates is the PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEArca: PCY). With an effective duration of 9.3 years, PCY, like other emerging markets bond ETFs, has at times proven vulnerable to a variety of speculation involving Fed action.