Investors should be careful when navigating the current environment and consider some ETF investment vehicles that are designed to outperform when interest rates rise.
On the recent webcast (available On Demand for CE Credit), Fight the Fed’s Rising Rates with Floating Rates, Kevin Flanagan, Senior Fixed Income Strategist at WisdomTree, highlighted a number of factors that market watchers have to consider, including the recent tax cut and increased spending expected to boost economic growth by a few percentage points; inflation expectations have risen; and the increasing U.S. budget deficits leading to increased Treasury supply, coming at a time when the Federal Reserve is pulling back on their reinvestments.
Overall, we can anticipate further strengthening in the economy, which will lead to a tighter monetary policy out of the Fed. For instance, the government recently revealed the U.S. economy expanded at a 4.1% rate, its best quarterly performance since 2014. The steady growth has also translated to rising inflation.
Meanwhile, fixed-income investors may find it harder to generate stable returns through traditional bond exposures or a heavy tilt toward U.S. Treasuries. Flanagan warned that the U.S. budget deficit has widened and the Treasury Department has been increasing supply of U.S. Treasuries – Treasury supply for the fiscal year 2018 is expected to be in the $1 trillion to $1.5 trillion range, compared to the $519 billion issued for the fiscal year 2017. On the demand side, the Federal Reserve, which has been a huge buyer of government debt, is now cutting back and steering toward normalization rates.
Consequently, investors will have to adapt their portfolios to meet the changing environment. Flanagan argued that fixed-income investors can find a “Fed-centric” solution by looking to a floating rate strategy, such as the WisdomTree Bloomberg Floating Rate Treasury Fund (NYSEArca: USFR). Since their launch in 2014, Floating Rate Notes have outperformed short-term T-bills. Floating-rate notes have a weekly reset and can more quickly adjust to higher rates as opposed to locking in a static yield for several months.
“Given the potential for additional rate hikes in 2018 & 2019 ‘Fed protection’ seems warranted,” Flanagan said.
Furthermore, investors can also look to enhance their yield generation as a way to mitigate potential pullbacks. Something like the WisdomTree Barclays U.S. Aggregate Bond Enhanced Yield Fund (NYSEArca: AGGY) or WisdomTree Barclays Yield Enhanced U.S. Short-Term Aggregate Bond Fund (BATS: SHAG) can increase income potential of core fixed income while continuing to benefit from the risk mitigation and diversification of a multi-sector portfolio.