As many consider ways to diversify in a rising interest rate environment, investors can also look to a new group of smart beta or factor-based bond exchange traded fund strategies.
On the recent webcast, Introducing Factors to Fixed Income ETFs, James “J.R.” Rieger, Head of Fixed Income Indices at S&P Dow Jones Indices, outlined the evolution in factor-based indices that helped give rise to the growing group of smart beta ETFs.
In the beginning there were traditional beta-index, capitalization-weighted funds that tracked broad markets like the S&P 500, but they soon evolved into a subset of the broader market, targeting areas like small- and mid-caps. Now, we have a growing number of factor-based index strategies that focus on specific return patterns or characteristics like low volatility or quality, among others.
Looking ahead, Rieger considers the next step to include smart beta fixed-income strategies, such as the relatively new S&P U.S. High Yield Low Volatility Corporate Bond Index, which serves as the underlying benchmark for the recently launched IQ S&P High Yield Low Volatility Bond ETF (NYSEArca: HYLV).
At S&P Dow Jones Indices, Rieger pointed out that the index provider is increasingly focusing on smart beta strategies as demand for these customized index solutions continue to rise among financial advisors, retail investors and even institutional investors.
“Investor appetite for tailored exposures via alternative weighted indices has accelerated in the past two years,” Rieger said.
With a greater portion of the smart beta equities market already filled out, indexers are shifting their focus to the fixed-income space as a changing landscape may create opportunities for targeted strategies. Specifically, Rieger pointed to a number of elements that are affecting the bond markets today, including ongoing demand for yield, rotation out of “bond” alternatives, rising inflation expectations, trump uncertainty and Federal Reserve’s monetary policy.
Consequently, investors may turn to factor-based ETFs to gain an edge in the fixed-income space. For example, HYLV is a rules-based, fixed income ETF that specifically tries to target lower volatility exposure in high yield debt. The IQ Enhanced Core Bond U.S. ETF (NYSEArca: AGGE) and IQ Enhanced Core Plus Bond U.S. ETF (NYSEArca: AGGP) incorporate momentum factors to direct investors toward strengthening fixed-income segments in an attempt to enhance returns.
Salvatore Bruno, Chief Investment Officer and Managing Director of IndexIQ, explained that AGGE and AGGP’s momentum following strategy may allow investors to following a trend following style that has resulted in overperformance in the long-term as opposed to a contrarian investor betting on a reversal of recent trends.
The fixed-income momentum risk and reward benefits are also historically been consistent with those in the equities market.
Bruno also pointed out that during periods of market stress, the moment strategy has also withstood the volatility, typically outperforming or at least doing less poorly than the widely observed Barclays Agg.
Rieger argued that as we head toward a period of higher volatility with rising rates and widening credit spreads, some investors may have turned to higher yielding corporate bonds for the attractive income yields, which may help cushion any potential fallout. However, a low-volatility focus may also help diminish drawdowns.
For example, HYLV’s underlying index ranks each of its holdings according to its marginal contribution to risk, or MCR, a measurement of the amount of risk a security contributes to a portfolio of securities. The measure is calculated using a bond’s duration and the difference between the bond’s spread and a weighted average spread of the bonds in the broader index universe. Those with a higher MCR will add more credit risk than debt with a lower MCR. The underlying index will then only select the 50% of bonds measured to have the least credit risk based on their MCR.
Historical data has shown that low-volatility high-yield bonds have outperformed over the long haul, preserving the yield pickup of high yield bonds while lowering the credit risk, compared traditional high-yield bond benchmarks.
“A basket of low MCR high yield bonds contains higher quality credits and has the potential to outperform the broad high yield universe during times of widening credit spreads,” Bruno said.
“With the Federal Reserve taking steps to normalize monetary policy, a high yield low volatility strategy may be an attractive option for investors concerned with rising rates.”
Financial advisors who are interested in factor-based fixed-income strategies can watch the webcast here on demand.