About two weeks ago, the Federal Reserve continued its trek towards higher interest rates, raising the federal funds rate for a third time this year by 25 basis points to its current level of 2.25 with possibly more to come as incoming data continues to support economic growth. This rise in rates has wreaked havoc on fixed-income ETF portfolios, according to data extrapolated by Matthew Bartolini, Head of SPDR Americas Research, but there are ways to shore up this offense of rising rates with a strong defense.
Fixed-income ETFs have given nascent and seasoned bond investors alike an opportunity to allocate capital into the bond markets under the guise and benefits of an ETF wrapper. However, performance has been mixed, especially when it comes to focusing on the largest fixed-income ETFs based on research by Bartolini:
- 9 of the 30 largest fixed income ETFs had losses in 100% of rolling one-month periods from December 31, 2012 to September 28, 2018
- 18 of the 30 ETFs had losses in 90% of the rolling one-month periods
- 24 out of 30 ETFs recorded losses in 75% or more of these periods
- Notably, losses weren’t confined to any particular fixed income category
With U.S. equities in the midst of an extended bull run in this late market cycle, could the risk-on mentality taken on by investors be driving attention away from bonds with a laser focus strictly on stocks? Bartolini refutes this notion, but it has impacted tax loss harvesting opportunities–a strategy that involves selling securities at a loss in order to offset capital gains tax liability.
“The run-up in equities over the last 10 years has not had an impact on the severity of losses on bond funds,” Bartolini told ETF Trends. “Now, while it hasn’t has an impact on the severity of the losses, it has an impact on tax loss harvesting opportunities, meaning that the outsized gains in stocks have made the losses on bond funds one of the few areas in a portfolio to conduct active tax loss harvesting. Overall, the losses on bond funds are a result of the Federal Reserve hiking rates more regularly since the end of 2016.”
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With more rate hikes expected to come in the Fed’s current monetary policy agenda, Bartolini identifies the pressure on bond portfolios this has been effectuating irrespective of whether they are long or short duration. In addition, fiscal policy has also been a major factor in bond performance.
“Longer or intermediate bond funds have been affected by the Fed’s monetary policy actions. However, fiscal policy has also had an impact,” said Bartolini. “The 10-year spiked at the beginning of the year once the tax cuts were passed and debt issuance by the US government increased to fund the cuts, expanding the already high budget deficit. These actions have had an impact on inflation and longer term rates, sending them higher and bonds lower, leading to losses on particularly bond funds sensitive to those key rate durations. ”
So how do fixed-income investors defend their ETF portfolios against a rising rate offensive? Bartolini offers a three-step approach of being short, going afloat and getting active.
1. Play the Short Game and Focus on Maturity Profile
With the short-term rate adjustments being instituted by the Federal Reserve, Bartolini recommends investors limiting exposure to long-term debt issues and focusing on maturity profiles. An example would be the SPDR Portfolio Short Term Corp Bd ETF (NYSEArca: SPSB), which seeks to provide investment results that correspond to the performance of the Bloomberg Barclays U.S. 1-3 Year Corporate Bond Index.
SPSB invests at least 80 percent of its total assets in securities designed to measure the performance of the short-termed U.S. corporate bond market. Ideally, shorter-term bond issues with maturities of three to four years are ideal to minimize duration exposure should the bull market enter a correction phase.
“To mitigate the impact of rising short-term rates, investors can consider targeting specific duration profiles,” said Bartolini. “In the past year, targeting the 1-3 year corporate maturity band vs. the 1-5 year band would have delivered 60 basis points of outperformance. Yields are comparable (3.31% vs. 3.41%), but the 1-3 year space has almost one year less of duration.”
2. Focus on Floating Rate Structures
A floating rate component that moves in conjunction with rate hikes will be beneficial if the Fed continues to remain hawkish on the economy. As such, Bartolini recommends the SPDR Blmbg Barclays Inv Grd Flt Rt ETF (NYSEArca: FLRN), which seeks to provide investment results that correlate with the price and yield performance of the Bloomberg Barclays U.S. Dollar Floating Rate Note < 5 Years Index.
“Floating rate notes with coupons that adjust to movements in LIBOR may be a more optimal solution to mitigate duration-induced price declines,” said Bartolini. “Since 2003, in months where the US 2-year yield has increased, a floating rate note exposure has outperformed a fixed rate exposure with the same maturity band by an average of 0.25% to 0.07%. The floating rate note exposure also had positive returns in 90% of those months vs. 52% for fixed rate. Floating rate notes tethered to LIBOR can also provide income as yields sit north of 2.6% following LIBOR’s 132% increase since 2016.”
In addition, Bartolini suggests investors take a look at senior loan options like the SPDR Blackstone / GSO Senior Loan ETF (NYSEArca: SRLN) as an alternative to high yields should they come under pressure as the Fed continues to increase rates. SRLN seeks to provide current income consistent with the preservation of capital through investing in the Blackstone / GSO Senior Loan Portfolio.
“If growth were to slow as the Fed hikes rates, high yield valuations might come under pressure, leading to spread widening,” Bartolini said. “Defensively positioning credit-oriented high yield portfolios while earning yield may be ideal. Senior loans are higher in the capital structure and have historically withstood spread widening better than fixed rate high yield, outperforming by an average 0.59% when credit spreads widen. Loans are also floating rate and will likely see coupons rise along with Fed hikes.”
3. Go Active in the Core
Lastly, Bartolini suggests using actively-managed options like the SPDR DoubleLine Shrt Term TR Tact ETF (BATS: STOT). STOT seeks to maximize current income with a dollar-weighted average effective duration between one and three years.
“Active security selection across a wide range of security types, regardless of their listed maturity date, may balance a portfolio between credit and interest rate-sensitive sectors while providing an attractive yield and duration profile,” said Bartolini. “Actively combining different credit and interest rate sensitive sectors may strike a better balance of yield and risk than traditional core or short-term core indexed approaches.”
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