As the Federal Reserve winds down its loose monetary policies and the U.S. dollar begins to strengthen, financial advisors should adapt their fixed-income portfolios and bond exchange traded fund weightings to capitalize on potential opportunities ahead.
On the recent webcast, Rethinking Fixed Income: Bond ETFs for the Next Cycle, State Street Global Advisors Research Strategist Matthew Bartolini points to three risks in the fixed-income market environment: A potential slowdown in the U.S. economy could force the Fed to hike rates later than anticipated. Rates are increased sooner-than-expected due to falling unemployment rates but wages remain the same. Lastly, the Fed hikes rate on schedule but geopolitical risks and volatility force down Treasury yields as traders buy safe-haven assets.
Due to the changing markets, both Bartolini and SSgA Portfolio Strategist Andrew Goodale argue that investors should not rely on the Barclays US Aggregate Bond Index as a benchmark since the index provides unattractive yield per unit of duration. [Shorter May be Better With Junk Bond ETFs]
Investors can no longer just hold fixed-income assets and expect attractive returns. The bond market has enjoyed a three-decade-long bull rally, but with rates hovering near record lows, the path forward could grow choppy.
“The path of interest rates moving forward is not clear, but it would appear difficult to replicate the prior 30 year bull market,” Goodale said.
Looking ahead, Goodale anticipates rates could fall three trajectories. In a high-growth and hyperinflation scenario, rates would increase quickly, so investors should diversify away from fixed-income assets. In a moderate growth and normalized rate environment, growth and hybrid assets would outperform. Lastly, if growth is low with deflationary pressures, long duration exposure would provide a hedge.
While interest rate risk is important, Bartolini reminds investors that credit risk is also a factor. The strategists argue that investors can exploit opportunities ahead by adding greater credit exposure through corporate bonds. Additionally, the corporate bonds may also lower rate risk through lower durations while maintaining comparable yields.
In response to rising rate risks, more financial advisors are willing to move down the yield curve and invest in short duration ETFs, according to a recent ETF Trends survey.
For instance, a re-weighted aggregate bond portfolio would include government debt exposure, such as the SPDR Barclays Short Term Treasury ETF (NYSEArca: SST) and SPDR Barclays Intermediate Term Treasury ETF (NYSEArca: ITE), and corporate bond exposure, inclulding the SPDR Barclays Short Term Corporate Bond ETF (NYSEArca: SCPB), SPDR Barclays Intermediate Term Corporate Bond ETF (NYSEArca: ITR) and SPDR Barclays Long Term Corporate Bond ETF (NYSEArca: LWC), along with securitized debt through SPDR Barclays Mortgage Backed Bond ETF (NYSEArca: MBG).
Alternatively, the strategists point out that investors can expand on the aggregate bond portfolio with below investment-grade debt and floating rate exposure to potentially increase yield while lowering the portfolio’s overall duration.
For example, the SPDR Barclays Investment Grade Floating Rate ETF (NYSEArca: FLRN) tracks investment-grade quality corporate debt that adjusts or floats its interest rate in response to the rest of the market. The SPDR Blackstone/GSO Senior Loan ETF (NYSEArca: SRLN) also floats its rate but includes speculative-grade debt holdings. The SPDR Barclays Short Term High Yield Bond ETF (NSYEArca: SJNK) tracks junk bonds with a focus on short duration. Alternatively, the SPDR BofA Merrill Lynch Cross Over Corporate Bond ETF (NYSEArca: XOVR) includes so-called cross over debt, which has less credit risk than many high yield bonds and generally offers higher yields than most investment grade bonds.
Financial advisors who are interested in learning more about investing in fixed-income assets can listen to the webcast here on demand.