As the markets brace for the Federal Reserve to begin hiking interest rates, bond exchange traded fund investors should thinking rate risk and ways to mitigate the negative effects higher rates.
On the recent webcast, Fixed Income Strategies Ahead of the Fed, Scott Eldridge, Director of Fixed Income ETF Product Strategy at Invesco PowerShares Capital Management, points out that the Fed Funds Futures, an indicator of the market’s expectations for an interest rate move, reveals that investors believe there is almost a 70% chance the Federal Reserve will hike rates this month.
“Absent negative surprises, December looks like a go,” Eldridge said.
However, looking at government bonds, U.S. Treasury yields may not immediately shoot up but gradually rise as global bond yields remain an anchor. The low rates abroad will help steer global investors toward the relatively more attractive yields in U.S. Treasuries.
Bond investors, though, should start thinking about the consequences if rates begin the normalization process.
“Look for ways to tilt portfolio away from rate risk,” Eldridge added. “Be wary of getting too defensive and creating imbalances”
As a way to diminish exposure to rate risks, Herb Morgan, CIO and CEO of Efficient Market Advisors, advises investors to underweight fixed income relative to benchmarks with a strong tilt toward low duration and favor adjustable securities.
Eldridge also points out that speculative-grade bonds may offer enough yields to help offset the negative effects of rising yields. Specifically, he pointed to senior bank loans, which have outperformed broader high-yield assets amid rising rates. Additionally, bank loans include significantly lower energy exposure than broader high yields, which may leave bank loans less vulnerable to default risks as oil prices remain depressed.