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.
For senior leveraged bank loan exposure, James Reiger, Global Head of Fixed Income at S&P Dow Jones Indices,pointed to the S&P/LSTA Leveraged Loan 100 Index, the underlying index for the PowerShares Senior Loan Portfolio (NYSEArca: BKLN).
Since the senior loans have rates that adjust periodically, the floating-rate loans offer investors an alternative method of earning yields with little or no interest-rate risk. Additionally, due to their floating rate component, bank loans are seen as an attractive alternative to traditional corporate bonds in a rising rate environment.
“When interest rates rise, so do the coupons, with some floating rate coupons subject to floors, or lower boundaries,” according to Invesco PowerShares. “The lower duration of senior loans has typically exposed investors to less overall price volatility than high yield bonds. Floating rate loans has typically been less sensitive to changes in interest rates than high yield bonds.”
BKLN has an average 33.55 day reset period – the average number of days until the floating component of the loans reset. The ETF also comes with an attractive 6.05% 30-day SEC yield. The underlying index only has a 1.5% tilt toward the oil & gas sector and 3.5% in metals & mining, another area that faces rising default risk in face of low industrial metals prices.
Additionally, Eldridge mentioned that the variable rate market for high-yielding preferreds exhibits stable rate risk. While traditional preferred stocks may experience greater rate risk, variable rate preferred securities have lower durations.
For example, the PowerShares Variable Rate Preferred Portfolio Fund (NYSEArca: VRP) usually trades more like bonds with shorter durations, so more conservative investors may find the lower-risk profile appealing. Specifically, VRP has an effective duration of 3.94 years and comes with a 5.19% 30-day SEC yield.
Financial advisors who are interested in learning more about fixed-income strategies can listen to the webcast here on demand.