Even though the Federal Reserve left rates unchanged, fixed-income exchange traded fund investors can still take steps to diminish the negative effects of higher interest rates down the line.
On the recent webcast, Fixed Income, Portfolio Construction and The Fed, Matthew Bartolini, Research Strategist at State Street Global Advisors, points out that the probability of an interest rate move incrementally rises for each Fed meeting ahead, including a 59% chance in December, 77% chance in March 2016 and 88% in June 2016.
We don’t necessarily need a Fed rate hike to see interest rates rise. With expectations of a higher interest rate as we get further along, fixed-income investors may witness yields rise, or bond prices fall, even before a definite Fed rate hike.
“The yield curve steepened in August even as Fed funds rate expectations were kicked down the road,” David Mazza, Vice President and Head of Research at State Street Global Advisor, said.
Other short-term factors may also affect rate moves and bond prices as well. For instance, the People’s Bank of China was dumping Treasuries after recently devaluing its currency.
“The yield curve may have steepened from the Chinese central bank liquidating reserves to support the yuan and limit capital outflows after it was devalued,” Mazza added.
Consequently, investors may turn to a re-weighted aggregate bond portfolio with a shorter duration to limit interest rate risk, which 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, including the SPDR Barclays Short Term Corporate Bond ETF (NYSEArca: SCPB) and SPDR Barclays Intermediate Term Corporate Bond ETF (NYSEArca: ITR), along with securitized debt through SPDR Barclays Mortgage Backed Bond ETF (NYSEArca: MBG). Moreover, the SPDR Barclays Short Term High Yield Bond ETF (NSYEArca: SJNK) tracks junk bonds with a focus on short duration.
SST has a 2.65 year duration and a 0.84% 30-day SEC yield. ITE has a 3.81 year duration and a 1.13% 30-day SEC yield. SCPB has a 1.95 year duration and a 1.69% 30-day SEC yield. ITR has a 4.38 year duration and a 2.72% 30-day SEC yield. MBG has a 4.57 year duration and a 2.53% 30-day SEC yield. SJNK has a 2.35 year duration and a 6.48% 30-day SEC yield.
While fixed-income investors can go down the yield curve to short-duration bonds to hedge against rising rates, there is more than one way to skin a cat.
For instance, Mazza pointed to floating rate exposure to diminish rate risk. Floating rate notes adjust their coupon based on movements in short-term rates, or Libor, while normal fixed-rate bond coupons do not. Additionally, investors who want more income within a floating rate structure and are more tolerant of credit risk can also look at senior loans as well.
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.
FLRN has a duration of 0.13 years and a 0.65% 30-day SEC yield. SRLN adjusts its floating rate component every 30 days and has a 4.51% 30-day SEC yield.
Mazza suggests a fixed-income portfolio of these shorter duration bond ETFs would include something like 15% ITE, 17.5% SCPB, 17.5% ITR, 15% SJNK, 10% SRLN, 10% FLRN and 15% MBG. The resulting portfolio woudl produce a yield to worst of 2.6%, an average duration of 2.9% and a credit spread of 177 basis points.
Bill Ahmuty, V.P. of Fixed Income ETF Capital Markets & Institutional Sales at State Street Global Advisor, also pointed out that ETFs have helped investors track a more liquid fixed-income market.
“Since 2009, the size of the Fixed Income Mutual Fund Market has continued to grow, while the use of traditional Credit instruments has fallen,” Ahmuty said. “As investors continue to seek alternatives to traditional Credit instruments, the ETF Fixed Income Market may possess potential for growth.”
Financial advisors who are interested in learning more about fixed-income assets can listen to the webcast here on demand.