Bonds are on the rise this year and predictions that the Fed will finalize rate hikes in the first half of the year could mean stabilization for volatile bonds markets. With the economic downturn and recession potential in the U.S. likely to impact equities much of the year, advisors and investors are looking to the income opportunities within bonds once more after the challenges of 2022.
The benchmark bond ETF, iShares Core U.S. Aggregate Bond ETF (AGG) is up 3.08% year-to-date while the Vanguard Total Bond Market ETF (BND) is up 2.96%: it’s the best start to the year for the Bloomberg US Aggregate Bond Index, the underlying index for AGG since 1989 reported the WSJ.
The Fed is predicted to hike interest rates in the ballpark of 5% in the next few months and then hold them there through much of the year as it continues to fight persistent inflation. Niall O’Sullivan, CIO of multi-asset strategies for Europe, the Middle East, and Africa at Neuberger Berman, believes that inflation will be stickier than investors are currently planning for, prompting the Fed to keep rates elevated for longer.
This persistent inflation is likely to have increasing impacts on equity earnings as companies near the tolerance level of price increases for consumers, O’Sullivan explained to WSJ. In such a challenging environment for equities, there lie opportunities within bonds that are now offering higher yields and meaningful cash coupons, particularly as the bond market stabilizes.
“Following aggressive Fed action in 2022, there is now income to be accessed with fixed income ETFs. In addition, fixed income ETFs likely will provide more ballast to a portfolio than it did last year as the Fed’s actions slow down,” said Todd Rosenbluth, head of research at VettaFi.
Capturing Enhanced Income Within Bonds With BNDI
BNDI is an actively managed ETF that seeks to offer enhanced monthly income distributions for investors by investing across the broad U.S. Aggregate Bond Market while also implementing a tax-efficient options strategy that generates additional income. The fund invests in the Vanguard Total Bond Market ETF (BND), which had net flows of $754 million in the last four weeks, and the iShares Core U.S. Aggregate Bond ETF (AGG), which had net flows of $1.55 billion in the last four weeks, to gain broad exposure to the U.S. bond market.
The income and capital gains that BNDI receives from its bond allocations are then enhanced by the addition of monthly income from the fund’s put option strategy on the S&P 500 that sells short puts while also buying long puts to protect for volatility.
The strategy is expected to offer positive returns in both flat and rising equity markets and can generate positive returns in moderately declining equity markets as long as the premium from the puts bought and sold is greater than the cost to close out the positions. Additional benefits of an options-based strategy can mean that the fund may offer a lower correlation to certain risk factors, including duration, credit, and inflation risk.
The put options that the fund uses are not ETF options but instead are S&P 500 index options that are taxed favorably as Section 1256 Contracts under IRS rules. This means that the options held at the end of the year are treated as if they had been sold on the last market day of the year at fair market value, and, most importantly, any capital gains or losses are taxed as 60% long-term and 40% short-term no matter how long the options were held. This can offer noteworthy tax advantages, and the fund’s managers also may engage in tax-loss harvesting opportunities throughout the year on the put options.
BNDI currently has a distribution yield of 5.06% as of December 30, 2022, and an expense ratio of 0.58%, and it could be a noteworthy income opportunity within bonds in 2023.
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