Despite the low yields and lack of future catalysts to bolster the space, corporate credit and government bonds exchange traded funds still have a place as a core diversifier in investor portfolios.
Many investors are worried about the prospects of the fixed-income space after yields fell over the past three decades and the Federal Reserve’s shifting stance on its loose monetary policy. However, bonds will continue to provide investors with a source of stability during times of duress, Financial Times reports.
Investors can stick with heavy positions in fixed-income, the asset class with the best risk-adjusted returns over the past decade. Investors can also try shift over to equities and floating rate fixed-income to avoid rate risks. On the other hand, people can hedge with a diversified allocation of both bonds and stocks.
A heavy position in fixed-income may be out of the question as it is unlikely investors will enjoy the same level of risk-adjusted returns experienced over the past. Over the past five years, U.S. government bonds that mature in five to seven years showed an annualized return of 4.4%, a volatility of 4.5% and a return-risk ratio of about 1.0% while investment grade credit returned 7.5% at a 5.2% volatility and a ratio of more than 1.4.
Related bond ETFs, iShares 7-10 Year Treasury Bond ETF (NYSEArca: IEF) and iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEArca: LQD), show similar returns, up an average annualized 5.7% and 7.6%, respectively. [Considering Core Intermediate Bond ETFs]
However, to produce similar risk-adjusted returns in the next five years, five-year Treasury yields would need to dip to below minus 1%, or credit spreads between Treasuries and corporate debt would have to break record lows.
The heavy equity approach may not help investors gain outsized returns either, since valuations are either at or above fair market value, with a lower return-risk ratio of 0.5.
Some have also turned to floating rate debt, such as iShares Floating Rate Bond ETF (NYSEArca: FLOT), which automatically adjust at periodic intervals in response to changes in the interest rates. However, Mark Haefele, global chief investment officer at UBS Wealth Management, argues that these types of assets do little to provide diversification. [Bond ETF Strategies to Shield Against Rising Rates]
Consequently, the analyst argues that a 50% U.S. investment-grade fixed-income and 50% U.S. equity portfolio would provide the best risk-adjusted return, with a 5.9% return, a 7.9% volatility and a given return-risk of 0.7.
For more information on the fixed-income market, visit our bond ETFs category.
Tom Lydon’s clients own shares of LQD.