While the economy is still continuing to expand, risks are rising. With many expecting a rising interest rate environment, bond exchange traded fund investors should be thinking about ways to mitigate the risks ahead.
On the recent webcast (available on-demand for CE Credit), PIMCO’s Fixed Income Strategy for 2017, Jerome Schneider, Head of Short-Term Portfolio Management at PIMCO, pointed out that since the elections, the markets have focused on inflation and pro-growth potential.
Consequently, many anticipate the Federal Reserve will raise interest rates to head off an overheating economy, which will weigh on bond markets.
Alternatively, investors can turn to active management for capital preservation and volatility reduction, Schneider said. For example, an actively managed bond portfolio can utilize active yield curve management to dampen overall volatility attributed to interest rate risk and target attractive names or sell names after they reach fair value to adjust credit risk.
Moreover, given the reforms in the money market segment as regulators try to obviate another Lehman Brother’s event, an active ultra-short-duration bond strategy is essential to maintaining purchasing power preservation in the post money-market reform world, Schneider added.
With the current market risks, PIMCO suggests that the most effective “shock absorbers” are derived from liquidity premiums, curve positioning and credit spread, whereas factors like duration and currency are among the largest contributors to portfolio volatility.
For example, after the extended fixed-income bull market, Schneider suggested that BBB-rated corporate credit provides improved risk-adjusted returns, compared to higher quality debt.
“If you look at spreads of BBB vs. A-rated corporates, we’re able to pick up a significant premium by holding BBBs,” Schneider said. “But in our mind, there’s often little distinction between these securities. … One area where we tend to find value is by targeting BBB Corporates, which offer a yield pick-up over A-rated corporates but have a similar risk profile.”
Meanwhile, higher quality debt such as long-term Treasury bonds now expose investors to greater risks. Looking at the duration of the Barclays U.S. Aggregate Index since December 2008, interest rate risk has increased 50% as the benchmark bond index increased its Treasury exposure. On The other hand, yields have declined in response to unprecedented global monetary policies.
Bond investors seeking to diversify their bond portfolios and limit interest rate risks may turn to actively managed short-term strategies that could allow for more options to protect capital and manage liquidity while generating income.
For example, the PIMCO Low Duration Active ETF, (NYSEArca: LDUR) and the PIMCO Enhanced Short Maturity Active ETF (NYSEArca: MINT) are backed by an active management team to select opportunities in low-duration bonds. The active manager has the flexibility to go beyond traditional government debt and include other debt securities like corporate credit to diversify and limit potential risks.
“We’re able to identify value in each of these sectors and tailor a portfolio that has a return profile we like, but with strong downside protection as well,” Schneider said. “MINT is able to actively allocate across sectors, whereas a passive index strategy is by definition constrained. In this way, we’re able to generate a higher yield with less interest rate risk.”
Financial advisors who are interested in learning more about fixed-income strategies for 2017 can watch the webcast here on demand.