Fixed-income ETF investors should look into the opportunities in the short-end of the yield curve to generate income while mitigating duration risk and consider ways to blend active and passive exposures to position portfolios in today’s bond market.
On the recent webcast (available On Demand for CE Credit), Fixed Income As Rates Rise, Matthew Bartolini, Head of SPDR Americas Research for State Street Global Advisors, warned that fixed-income investors will have to adapt to rising short-term rates and a flattening yield curve as the Federal Reserve tightens its monetary policy.
After the Fed hiked rates, yields on U.S. 2-year notes have increased to 2.57% in late May from 1.16% back at the end of 2016. Looking ahead, if the Fed raises rates two more times to an upper bound of 2.50%, yields on 2-year notes are expected to rise to around 3.41%.
Consequently, Bartolini argued that fixed-income investors should become more selective on bond types, term and structure to better adapt to monetary tightening. Specifically, he pointed out that widely observed benchmarks like the Bloomberg Barclays U.S. Aggregate Bond Index and Bloomberg Barclays U.S. Corporate Bond index both exhibit high duration or rate risk, which has contributed to increased drawdowns in a rising interest rate environment.
Alternatively, investors may shift down the yield curve and look to investments in short-term debt or other fixed-income strategies to limit duration or rate risk. For example, Bartolini pointed to the Bloomberg Barclays U.S. Floating Rate Notes and S&P/ISTA U.S. Leveraged Loans 100 Total Return Index as attractive options that produce yields with close to zero duration risk.
Furthermore, Bartolini showed that senior loans may also be an attractive alternative to high-yield bonds as a income-generating strategy due to its lower correlation to other asset classes, which further helps the senior loans limit potential downside risks. For instance, senior loans showed a 0.43 correlation with the S&P 500, compared to high yield bonds’ 0.57 correlation to the S&P 500.
Rob Glownia, Fixed Income Portfolio Manager at Riverfront Investment Group, helped explain that investors could also access income ideas through non-traditional allocations toward categories in high-yield and bank loans, among others. These alternative strategies are especially noteworthy when Riverfront tries to adjust duration/yield curve positions by shortening the duration or adjust a portfolio’s yield curve positioning as economic, market and monetary conditions warrant.