ETF Trends
ETF Trends

As investors consider ways to adapt to a changing interest rate environment, a new breed of smart beta fixed-income exchange traded fund strategies may help limit risks.

“We think this is particularly important for bond investors as they need to spot quality and value while keeping in mind the impact of interest rate risk and credit risk,” according to a BlackRock note.

Traditional bond ETFs may expose fixed-income investors to risks in a rising interest rate environment. For instance, many follow a market capitalization-weight methodology that would overweight the most indebted issuers. Furthermore, they target a specific range of maturities that could leave investors negatively exposed to changes in interest rates.

On the other hand, investors may consider smart beta bond ETFs to potentially deliver better performance than something benchmarked to the Bloomberg U.S. Aggregate Bond Index by accessing yield in a more balanced approach.

For instance, the previously active now turned passive ETF, iShares Edge U.S. Fixed Income Balanced Risk ETF (BATS: FIBR), will achieve three years of live performance on February 26 and is set to outperform the so-called Agg. Since its inception back in February 2015, FIBR has returned an annualized 2.54%, compared to the Agg’s 1.42% average return over the same period.

To achieve its performance, FIBR tracks the Bloomberg Barclays U.S. Fixed Income Balanced Risk Index, which includes corporate and mortgage securities taken from the broader Bloomberg Barclays U.S. Universal Index while targeting an equal allocation between interest rate and credit spread risk, so segments with lower credit spread volatility are given a higher weighting. The underlying index also further adjusts rate risk so that it equals credit spread risk by including long positions in U.S. Treasuries or short positions in Treasury futures.

The result is a portfolio that “aims to protect against rising rates by reducing the portfolio’s potential for concentrated interest rate risk,” according to BlackRock.

FIBR currently shows an effective duration of 4.83 years and a 2.84% 30-day SEC yield. The portfolio currently includes a -25.0% cash equivalent or derivatives hedge against rising rate risk and focuses on industrial, MBS pass through and financial institution debt securities. The portfolio’s smart beta indexing methodology may be a good way for bond investors to balance rate risk and their ongoing need for income.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.