Fixed-income investors should consider the risks of market-cap weighted bond funds and look to an alternative exchange traded fund methodology that could help diminish those risks ahead.
On the recent webcast, Advisor’s Guidebook to Fixed Income in Today’s Market, Edward Kerschner, Chief Portfolio Strategist, Columbia Threadneedle Investments; Matt Steiger, Director, Product Management, Columbia Threadneedle Investments; Joe Mallen, Chief Investment Officer, Helios Quantitative Research; and Jay McAndrew, National Sales Manager, Strategic Beta, Columbia Threadneedle Investments, outlined a changing bond market, with shifting interest rates that have the potential for traditional strategies to become susceptible to increased risks and lower payouts.
Fixed-income investors face a new rate regime where they will have to better manage income and account for income volatility ahead. There appears to be a logical inconsistency in utilizing a cap-weighted bond benchmark as an investment vehicle since they do not foster diversification, with correlations among the components high. Consequently, investors should consider a multi-sector bond strategy filtered for opportunity rather than indebtedness.
From the 1980s, the fixed-income market has enjoyed a prolonged bull run as yields on U.S. 10-year bonds declined from almost 15% to 2%. Fueling the rally in recent years, quantitative easing kept interest rates at unprecedented low levels. With growth back on track, central banks are bringing monetary policy back to normal. Given the Federal Reserve’s fund rates targets, long Treasury bonds have begun to price in future tightening.
Furthermore, U.S. tax reforms and a widening budget deficit, along with a growing economy, have raised concerns of rising inflationary pressures ahead, which could put additional upward pressure on interest rates.
Consequently, many investors face a heightened risk that with bond yields so low today, a modest uptick in yield could trigger greater negative returns.
Despite the heightened rate risks that bond investors face today, many still remain fixated on benchmarking their portfolios to the Bloomberg Barclays US Aggregate Bond Index Market Value. The so-called Agg is now worth more than $21 trillion.
Many bond investors now face greater exposure to unintended concentration risks. The Agg held 22% of its index in U.S. Treasuries at the end of 2007, but the tilt toward U.S. Treasuries has increased to 39% today. When factoring in debt issued by government agencies and mortgage-backed securities, the total government exposure is now over 70%. Furthermore, the Agg index has historically exhibited high correlations among the top components, with the correlation of the top two components – U.S. Treasuries and MBS – at 83%, and the benchmark holds minimal exposure to components with low cross-correlations. Consequently, the Agg now exhibits a low risk-reward profile, especially in the face of rising interest rates ahead.
Bond investors, though, can look to alternative income sources to enhance yields and returns while potentially diminishing risk exposures. For example, the Agg does not include sector exposures like High Yield, Global Treasuries or Emerging Market debt, which have much lower cross-correlations to U.S. Government debt. Moving out along that risk-reward profile to include these alternative income source that could provide access to less correlated opportunities with relatively high returns.
As a way to help investors gain a smarter exposure to the fixed-income market and diversify away from the shortcomings of a market cap-weighted bond index, Columbia Threadneedle offers the Columbia Diversified Fixed Income Allocation ETF (NYSEArca: DIAL), which follows an alternative indexing methodology.
The bond ETF tries to reflect the performance of the Beta Advantage Multi-Sector Bond Index, a rules-based multi-sector strategic approach to debt market investing. The underlying smart beta index covers six sectors of the debt market, focusing on yield, quality and liquidity.
By achieving its goal of yield enhancement, DIAL includes multiple sectors throughout the US and around the globe; excludes short term government with limited yield; excludes non-government with limited risk premium; and exclude negative yielding bonds.
The ETF’s quality management aims to avoid the “tails of the market” by removing sectors that offer no risk premium and lower quality tiers that have outsized downside risk, which essentially means no corporates rated below single-B ratings, no sovereigns rated below double-B ratings and no corporates longer than 15 year maturity.
Additionally, the fund keeps in mind liquidity limitations or focuses on issues with sufficient tradability to provide investors with liquidity, managed against volatility. The index screens for larger issue size, screens for recently issued securities and limits number of bonds per issuer.
Financial advisors who are interested in alternative bond strategies can watch the webcast here on demand.