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.
Looking ahead, Glownia outlined Riverfront’s current udernweight allocation to U.S. fixed-income, with a preference for credit over duration risk, or investment-grade corporate debt. The firm believes strong corporate earnings and balance sheets, the ability of companies to refinance at historically low rates, and income advantage relative to U.S. government debt are all attractive attributes. Beyond corporates, Glownia believes investors may find opportunity in short-duration high yield and levered loans due to the asset categories’ income advantage and low credit risk in a strengthening economy.
“With the Fed on track to continue gradual rate hikes, the yield curve may continue to flatten as short term rates rise in response. Consider shortening duration to mitigate price volatility without sacrificing yield potential. Floating rate structures may allow investors to harness the benefits of movements on the short end of the curve,” Bartolini said.
For example, the SPDR Barclays Investment Grade Floating Rate (NYSEArca: FLRN) can help hedge interest rate risks. The ETF follows the Bloomberg Barclays U.S. Dollar Floating Rate Note < 5 Years Index, which seeks to provide exposure to debt instruments that pay a variable coupon rate, a majority of which are based on the 3-month LIBOR, with a fixed spread. The notes’ have a so-called reset period with interest rates tied to a benchmark, such as the Fed funds, LIBOR, prime rate or U.S. Treasury bill rate. Due to their short reset periods, these floating rate funds have relatively low rate risk.
Investors could also complement existing credit positions in high-yield and investment-grade credit with alternatives like bank loans that access floating rate, move up the capital structure and shortens duration exposure. For example, the actively managed SPDR Blackstone/GSO Senior Loan ETF (NYSEArca: SRLN) could help investors with better exposure as a manager is more freely able to weave in and out of the fixed-income market.
The SPDR Portfolio Short Term Corp Bond ETF (NYSEArca: SPSB) provides exposure to the shorter end of the investment-grade corporate debt market. The fund seeks to provide investment results try to reflect the Bloomberg Barclays U.S. 1-3 Year Corporate Bond Index.
Additionally, the actively managed SPDR DoubleLine Short Duration Total Return Tactical ETF (Cboe: STOT) seeks to maximize current income with a dollar- weighted average effective duration between one and three years. The fund seeks to maximize total return over a full market cycle through active sector and security selection across a broad range of fixed income securities that could include, among others, securities issued or guaranteed by the US government, foreign and domestic corporate bonds, emerging market bonds and agency and non-agency mortgage backed securities.
Financial advisors who are interested in learning more about fixed-income investment strategies can watch the webcast here on demand..