The latest Morningstar data revealed that on average, most actively-managed bond funds in the intermediate-term bond category outperformed their passive peers through the end of 2017 based on durations of one-, three- and five-year periods.
Rising interest rates have presented a challenge for passively-managed funds, which may exclude a significant portion of the investable debt market that could offer investors more diversification if they allocated capital into an actively-managed fund. For example, rising interest rates can hurt fixed-income investors who have capital allocated to debt with fixed rates that don’t move with short-term rate adjustments made by the Federal Reserve.
Related: 5 Fixed-Income ETFs that Make the Investment Grade
The economy has been full steam ahead with the backing of a strong stock market that has seen the major indexes like the S&P 500 reach record levels. With no signs of slowing, it appears that a steady diet of rising rates is in order, according to Boston Federal Reserve President Eric Rosengren.
“Gradually increasing over the course of this next year makes sense,” Rosengren told CNBC in an interview. “If things work out well for the economy, and that’s what I expect and hope, then we’ll be in a situation where we need to have somewhat restrictive policy over time.”
With a monetary policy meeting slated for later this month, Rosengren also forecasts that the current federal funds rate will float between a range of 2.5% to 3%. After the two previous rate hikes earlier this year, the current federal funds rate stands at 2.
Investors can effectively position themselves to capitalize on these short-term rate adjustments, for example, by investing in the SPDR Blmbg Barclays Inv Grd Flt Rt ETF (NYSEArca: FLRN). FLRN seeks to provide investment results that mimic the performance of the Bloomberg Barclays U.S. Dollar Floating Rate Note < 5 Years Index.
At least 80 percent of assets will go towards securities that include U.S. dollar-denominated, investment grade floating rate notes. This floating rate component can take advantage of short-term rate adjustments by the Federal Reserve, while at the same time, protect the investor against credit risk with investment-grade issues and a duration of less than five years.
While floating rate corporate bond ETFs provide the necessary hedge against a rising rate environment, rising inflation can tamp down any returns realized from floating rate corporate bonds. As such, actively-managed funds can also help investors by supplementing floating rate bond ETFs with inflation ETFs like the IQ Real Return ETF (NYSEArca: CPI) as an option to hedge against inflation.
CPI seeks investment results that correspond to the IQ Real Return Index–a “fund of funds” that invests its net assets in the investments incorporated within the underlying index. Fixed-income investors using corporate bond ETFs are subject to duration risk tied to interest rates, but in an economic environment where inflation is also rising, an ETF like CPI would be of benefit.
One thing to note is that corporate bond ETFs with higher-yielding debt holdings that feature a floating rate component are also subject to credit risk as the bonds are typically tied to companies that are below investment-grade. This poses a risk to investors, particularly since companies tied to below investment-grade debt have a higher propensity to default.
As such, actively-managed funds can expose an investor to an investment-grade corporate bond ETF like the iShares Interest Rate Hedged Corp Bd ETF (NYSEArca: LQDH). LQDH seeks to mitigate the interest rate risk of a portfolio composed of U.S. dollar-denominated, investment-grade corporate bonds without being tied to an underlying index. LQD is actively-managed and seeks to invest in one or more underlying funds that principally invest in investment-grade bonds, and in U.S. Treasury securities (or cash equivalents).
When compared to the iShares Core US Aggregate Bond ETF (NYSEArca: AGG), LQDH has been outperforming AGG thus far this year–a 0.61% gain YTD for LQDH as opposed to a loss of 1.11% for AGG.
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