When it comes to bonds and fixed income ETFs, the longer the duration, the more sensitive the security is to changes in interest rates. Said another way, declining rates really benefit longer duration fare.
Take the case of the FlexShares Credit‐Scored US Long Corporate Bond Index Fund (NasdaqGM: LKOR). LKOR has a weighted average effective duration of 14.53 years and is up 18.44% year-to-date. The FlexShars fund yields nearly 4%.
LKOR tracks a fixed-income portfolio of corporate debt securities with a longer maturity selected based on a proprietary credit evaluation process.
LKOR excludes illiquid and smaller issuers to improve liquidity and transparency. Additionally, the fund targets company bonds that have a higher credit quality, lower risk of default and potential for higher yield and price appreciation. LKOR holds 186 bonds with a weighted average maturity of 23.52 years, according to issuer data.
Last year, rising interest rates were a main contributing factor in the downfall of investment-grade bonds. As the Fed hiked the short-term fed funds rate, longer-duration investment-grade bonds with historically low yields have appeared less attractive.
Reversing Course with the Fed
Fortunately for investors, the Fed is reversing course this year and with another interest rate reduction likely coming before 2019 is up, long-duration fare, such as LKOR, looks more appealing.
LKOR also features a lower weight to financial services issues than many traditional corporate bond ETFs. Issues from that sector represent just 18.41% of the fund’s weight while consumer and technology issues combine for about 47%.
LKOR allocates 47.30% of its weight to bonds in BBB territory.
“Some bond market observers fretted that issuers behind BBB-rated debt could be pinched if the economy slowed because many of those companies took advantage of low-interest rates and issued more debt. Then downgrades could come, forcing trillions of dollars of once IG debt into junk territory,” according to Nasdaq. “Conversely, other bond market observers argued that the above thesis was probably overblown and noted that the largest issues of BBB-rated bonds are defensive companies, such as financial services and consumer staples.”
For more on smart beta ETFs, visit our Smart Beta Channel.