As fixed-income investors look for ways to diversify their bond portfolios, consider innovative ETF strategies that can navigate current market risks, and potentially generate attractive yields.
In the recent webcast, Innovative Bond Strategies for a Low Yielding World, Ken Sommer, Managing Director, Head of Investment Grade Portfolio Management, New York Life Investments; Alexandra Wilson-Elizondo, Director, Portfolio Manager—Global Fixed Income, MacKay Shields; and John Lawlor, Director, Portfolio Manager/Trader, MacKay Municipal Managers, outlined the current market environment of diminishing yields, an uncertain monetary policy outlook and heightened market volatility, along with strategies to tackle these challenges.
The Federal Reserve has shifted from interest rate hikes last year to rate cuts this year, with the most recent rate reduction last week. However, the strategists pointed out that there is still a disparity between market pricing or Fed funds futures, compared to the Fed dot plotline, which suggests that the market is still more dovish than the Fed and is currently pricing in one rate cut in 2019. This disconnect between the Fed and the market could lead to potential bouts of volatility.
With the Fed engaging in a looser monetary policy, inflation could be a key determinant of Fed action going forward. The Fed will have to see inflation materially push above its 2% target for a sustained period, but inflation has remained stubbornly below its target. The same can be said for many other global central banks that are more worried about deflationary pressures.
Given the current market environment, many yield-hungry investors have turned to high yield exposure to generate more attractive returns. However, bond investors now face increased market volatility.
Factor-Based Investing
Alternatively, Sommer highlighted factor-based investing as a way to better manage risk. Specifically, given the reality of low-interest rates and the challenge for bond outperformance, the premise of the low volatility factor that minimizes drawdowns can potentially lead to higher returns over longer-term periods.
A strategy like the IQ S&P High Yield Low Volatility Bond ETF (NYSEARCA: HYLV) can identify low volatility, high yield bonds that have the potential to offer competitive income while managing downside risk.
Sommer pointed out that volatility rankings have acted as an early indicator of rating changes. After reviewing rating changes from B to BB and vice versa over a period from the 4th quarter of 1996 through the 2nd quarter of 2019, it was shown that a bond’s volatility ranking generally started to improve 25–30 months before the rating upgrade happened. Low-volatility bonds have also historically exhibited less credit risk than high volatility bonds.
Additionally, bond investors may seek low correlated, tax-exempt solutions through something like the actively manage IQ MacKay Shields Municipal Intermediate ETF (NYSE Arca: MMIT) and the IQ MacKay Shields Municipal Insured ETF (NYSE Arca: MMIN).
“Actively managed municipal bond ETFs combine what we believe to be the best features of ETFs and mutual funds into one solution: offer investors access to the professional management of an inefficient asset class within a cost-effective, liquid investment vehicle,” according to MacKay.
“We believe actively managed municipal ETFs provide a liquidity profile that is well aligned with today’s market and enables the manager to navigate and capitalize on market inefficiencies,” the strategists added.
The MacKay strategists argued that seismic shifts have created opportunities as the market has become less liquid and more volatile, which have increased the potential benefits of active management. For example, they underscored the declining broker-dealer inventories that have dipped to $20 billion in 2018 from $50 billion in 2017. Furthermore, new issues wrapped by issuers have also declined significantly to less than 10% in 2018 from 60% in 2007.
The municipal bond market is also filled with high-quality debt, with little history of defaults. Munis have historically exhibited lower default rates relative to corporate debt. For instance, according to Standard & Poor’s data, investment-grade municipal bonds have shown a cumulative historical default rate of less than 1%.
Lastly, bond investors can use the actively managed IQ Ultra Short Duration ETF (ULTR) to manage interest rate risk while seeking attractive current income. The bond strategy provides a high-quality approach to the short-end of the duration spectrum offers an appealing alternative to cash. As an investor moves to the ultra-short end of the yield curve, duration risk and volatility decrease dramatically, resulting in outsized risk-adjusted yields relative to other parts of the yield curve.
Financial advisors who are interested in learning more about innovative bond strategies can watch the webcast here on demand.