Fixed-income ETF investors should carefully consider the growing risks that many now face and look to a smart alternative that could help generate income while limiting potential downside risks.
On the recent webcast (available On Demand for CE Credit), The Fed, Factor Investing and Fixed Income, Jordan Farris, Managing Director and Head of ETF Product Development at Nushares from Nuveen, outlined the current fixed-income market environment where a Federal Reserve is planning to normalize interest rates with two more rate hikes later this year.
“As the economic cycle advances, the yield curve is starting to flatten, usually a signal that a recession is on the horizon,” Farris said. “Although a recession on the horizon may not necessarily mean it is imminent, investors may want to approach financial markets with caution.”
After enjoying a three-decade long bull run, the fixed-income market environment has greatly changed. U.S. Treasury debt issuance increased by 48% over the past 12 years – Treasuries now make up the major portion of U.S. investment-grade bond market. Since the credit crisis, U.S. investment grade bond yields have declined by about 50% while duration steadily increased. Meanwhile, we are witnessing a large transition of baby boomer investors from working to retiring.
Furthermore, Farris warned that the eight-year bull market and benign credit environment largely masked the risks of increasing equity exposure and relying on a broad U.S. bond market benchmark to meet investment needs.
“Core bond allocation techniques need to become more nuanced,” Farris said.
Factor-Based & Smart Beta Bond ETF Strategies
Alternatively, Farris argued that fixed-income investors may take a look at factor-based or smart beta bond ETF strategies to better manage risk and potentially enhance returns in this changing market environment.
“Many fixed income benchmarks weight by market cap and, as a result, may be allocating more weight to companies issuing more and more debt – a strategy that may seem counterintuitive,” Farris said. “The solution is to identify themes that have the potential to offer superior risk-adjusted returns or a more nuanced exposure to meet client needs.”
For example, Nushares fixed-income ETFs like the NuShares Enhanced Yield 1-5 Year U.S. Aggregate Bond ETF (NYSEArac: NUSA) may help fixed-income investors take an alternative approach to bond investing. The smart beta ETF focuses on factors like carry or the tendency for higher-yielding assets to provide higher returns, volatility or the tendency for lower-risk higher-quality assets to generate higher risk-adjusted returns, value or the tendency for relatively cheap assets to outperform, and momentum or the tendency for recent relative performance to continue in the near future.
The resulting portfolio overweights investment-grade BBB-rated debt, along with corporate and securitized credit, as compared to the broad U.S. investment-grade fixed-income market. Additionally, the factor-based bond ETF underweights U.S. Treasuries.
Robby Flink, Advisor for Infinity Financial Group, argued that investors and advisors could look to something like the NUSA as an alternative to the traditional Bloomberg Barclays U.S. Aggregate Bond Index as the smart beta ETF diminishes rate risk without a significant change to credit quality and yield.
Financial advisors who are interested in learning more about factor-based bond investments can watch the webcast here on demand.