Most fixed income investors have exposure to a market cap-weighted bond index, which may expose people to unexpected risks, especially in a rising rate environment ahead.
Alternatively, investors can look to a smart beta bond exchange traded fund strategy that follows a rules-based indexing methodology.
On the recent webcast (available on-demand), An Investment Grade ETF Strategy for Diversifying Income, Kevin DiSano, Managing Director and Head of ETF Sales at Nuveen, pointed out that many core bond investors today have seen yields fall off but don’t want to assume the greater risk associated with higher yielding segments and may be unwittingly exposed to greater interest rate and concentration risk.
The need for income is not going away, but investors are suffering from a low-yield environment. Specifically, the baby boomer generation is entering the retirement years, and many are living longer with life expectancy rising, are leading healthier lives with an overall decline in those reporting poor health and are more in debt with more continuing to incur mortgage payments even in retirement.
Most investors look to the benchmark Barclays U.S. Aggregate Bond Index as their guide to fixed-income investments. However, the index follows a market cap-weighted methodology, so issuers with the most debt have a higher weighting. Consequently, the Barclays Agg has increased its exposure to U.S. Treasuries over the past decade, which leaves the benchmark index exposed to greater interest rate risks, with a higher duration and lower yields.
Alternatively, DiSano argued that a strategic or smart beta approach may address concerns of a traditional market cap-weighted methodology.
[related_stories]Strategic beta ETFs are “designed to provide better risk/return profiles than market cap weighted benchmarks by assigning weights according to factors other than market cap,” DiSano said.
For example, the recently launched NuShares Enhanced Yield U.S. Aggregate Bond ETF (NYSEArca: NUAG) tries to reflect the performance of the BofA Merrill Lynch Enhanced Yield U.S. Broad Bond Index, which uses a rules-based methodology that allocates higher weights to securities and sectors with a higher potential yield while maintaining comparable risk. The strategy is based on the so-called carry theme, or the tendency for higher-yielding assets to provide higher returns as we have witnessed over the past decade.
The underlying index’s weighting is “based on yield. Assigns underweights or overweights at each subgroup level in an effort to enhance yield while maintaining comparable risk,” Jordan Farris, Vice President and Head of ETF Product Development at Nuveen, said.
Compared to the base index, the smart beta Enhanced Yield U.S. Broad Bond Index has a slightly greater tilt toward BBB investment-grade corporate debt, with a significant underweight toward AAA-rated U.S. Treasuries, which has helped NUAG generate higher yields.
“NUAG offers investors enhanced yield potential relative to the taxable U.S. investment grade fixed income market with comparable levels of risk and an alternative to market-cap weighted strategies,” DiSano said.
Looking ahead, most financial advisors plan on shortening their fixed income exposure or even decreasing allocations. In a survey of financial advisors attending the webcast, 29% indicated they plan on cutting down fund duration to limit the negative effects of rising interest rates while 20% plan on decreasing fixed income exposure.
Financial advisor who are interested in learning more about the fixed-income market can watch the webcast here on demand.