To say 2018 was an interesting year for fixed income investors is probably an understatement. Even as the Federal Reserve boosted interest rates four times, advisors and investors flocked to fixed income exchange traded funds.
By the time 2018 ended, bond ETFs accounted for nearly a third of all inflows to US-listed ETFs, with a hefty percentage of that capital heading to low and ultra-low duration funds.
While some fixed income market observers believe the Fed will slow its pace of rate hikes this year and some believe there will not be any rate increases at all, the new year brings new challenges and opportunities for bond ETF investors.
Bryan Novak, senior managing director at Chicago-based Astor Investment Management, LLC, recently discussed the firm’s Active Income strategy and opportunities for fixed income investors in 2019 with ETF Trends.
Inside Active Income
Astor’s Active Income uses a fundamental approach to fixed income investing, seeking attractive yield-to-risk ratios relative to intermediate-term Treasuries. At the end of 2018, average credit quality in the strategy was high at A- while duration was low at an average of 1.64 years, according to Astor data.
“Active Income is an unconstrained income-focused strategy that essentially seeks to find the optimal allocation across yield producing assets given the current environment,” said Novak. “You might say it tries to push the balance of yield for the risk in the investors favor. Yield is always there in some way, but the risks for that yield are not always in the investors favor.”
While Active Income is not a yield-focused strategy, it did sport a tidy yield of 4.24 percent at the end of last year, providing a high yield than 10-year Treasuries or the widely followed Bloomberg Barclays US Aggregate Bond Index.
“The strategy does not seek to make bets on where the best yield is, but rather takes a lower vol approach by diversifying across asset classes,” said Novak. “The strategy has done well to compliment core diversified bond portfolios that investors typically use, such as Bloomberg Barclays Aggregate Bond Index or other traditional fixed income exposure.
Astor Active Income has flexibility across fixed income segments. For instance, when allocating to investment-grade corporate bonds, the strategy can include ETFs such as the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA: LQD) and the actively managed iShares Short Maturity Bond ETF (CBOE: NEAR). NEAR has an effective duration of just 0.48 years.
The strategy can also feature high-yield corporate bond exposure via traditional ETFs or via senior loans and funds such as the SPDR Blackstone / GSO Senior Loan ETF (NYSEARCA: SRLN).
Senior secured floating-rate bank loans are seen as a way for fixed-income investors to maintain yield generation while hedging rate risk. Since the senior loans have rates that adjust periodically, the floating-rate loans also offer investors an alternative method of earning yields while mitigating interest-rate risk.
Keeping It Short
Last year, the top three bond ETFs in terms of new assets added were all short- or ultra-short term products. That group included the SPDR Bloomberg Barclays 1-3 Month T-Bill ETF (NYSEARCA: BIL). Much of investors’ enthusiasm for lower duration bond ETFs last year was tied to Fed tightening, but Novak sees reasons why short-term bond ETFs could remain popular this year.
“I think these will continue to gain attraction from investors. For one reason, while the economy has moderated, it is not indicating recession currently,” he said. “Additionally, as of recent, interest rates have backed off substantially on the risk-off move in Q4. While the Fed has backed off its rate hike pace, they are still in the midst of a hiking cycle.”
Astor Active Income has featured low duration ETFs such as NEAR and the $2.12 billion Invesco Ultra Short Duration ETF (NYSEARCA: GSY). GSY invests in bonds of varying maturities, but the bulk of its 265 holdings have an average duration of less than a year, giving the fund an effective duration of just 0.34 years.
“The risks are more balanced now, however short duration exposure should still be desired to balance out a yield portfolio at this point, at least in the first part of 2019,” adds Novak. “What would change that view would hinge on economic trends, and broader weakness could support. I would also add that an extension in term premium could entice investors to look further out.”
A Pragmatic Approach To The BBBs
Heading into 2019, one of the primary concerns in the investment-grade corporate bond market was the fragility of BBB-rated debt. Corporate bonds with BBB ratings are one to three notches above junk territory and by some estimates, the BBB market is littered with bonds that are just one step away from junk status.
Massive issuance of such bonds during the previous low interest rate environment is one reason for today’s BBB concerns. While those concerns could prove to be overblown, Novak advises prudence in this corner of the corporate bond market.
Our investment committee has had a number of conversations on rating silo, looking for options to carve out this segment,” he said. “The concern over large issuance in the BBB category and potential for rerating could ultimately end up overblown, but it I think it’s prudent to have a strategy that reflects this risk.”
The aforementioned NEAR, which has been held by Astor Active Income, allocates 35 percent of its weight to BBB-rated corporates, which is lower compared to many passive corporate bond ETFs.
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