A smart beta bond ETF strategy may help fixed-income investors navigate the changing market conditions and add value across various market cycles.
For example, the WisdomTree Barclays U.S. Aggregate Bond Enhanced Yield Fund (NYSEArca: AGGY) can help investors maintain core fixed income exposure while bolstering yield.
The fund uses a“rules-based approach and re-weights the subcomponents of the Bloomberg Barclays U.S. Aggregate Bond Index to enhance yield, while broadly maintaining familiar risk characteristics. AGGY tries to boost return by reweighting the components of the Aggregate Index. But this additional yield is not free as it comes with greater credit risk and rate risk.
“With the Federal Reserve (Fed) hiking interest rates at a measured pace, it seems to us that the central bank views economic conditions as strong. This gives us conviction in being over-weight credit. As a result, our income advantage should help investors generate returns during a period of rising rates, provided they do not rise rapidly. Later in the cycle, credit spreads will inevitably widen. As a result, nominal interest rates should fall as the Fed shifts its bias from tightening to easing. In our view, our Enhanced Yield strategy has the ability to add value across market cycles,” WisdomTree’s Bradley Krom, Associate Director of Research, and Matt Wagner, Research Analyst, said in a note.
AGGY shows an attractive 3.51% 30-day SEC yield and a 6.90 year duration. The portfolio leans toward 49.1% corporate bonds, followed by 31.8% mortgage-backed securities, 15.7% Treasury notes and 2.9% sovereign bonds.
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While some may be put off by the slightly higher duration and greater exposure to credit, WisdomTree argued that the strategy has maintained a yield advantage. Furthermore, the methodology as not relient on falling rates to generate excess returns versus the benchmark Barclays Aggregate Bond Index.
AGGY may bank on a strengthening economy as a stronger market will help support corporate credit.
“In our view, one of the primary takeaways that investors overlook in our Enhanced Yield Index is the concept of diversification. While our approach is generally over-weight interest rate risk versus the benchmark, it is also generally over-weight credit risk. With few exceptions, periods of rising rates generally coincide with faster economic growth, increases in inflation expectations and a healthier U.S. economy. As a result, credit spreads tend to tighten as the risk of ratings downgrades recedes,” the WisdomTree strategists said.
Additionally, a rising yield period does not automatically mean a bond strategy will underperform. Over the past seven quarters, a period in when 10-Year Treasury yields rose by more than 140 basis points, the yield-enhanced Index outperformed the widely observed Agg by 80 basis points annualized.
“Bottom Line: A credit over-weight resulted in higher income and the ability to benefit from tighter spreads despite the headwinds of increased duration during a rising rate environment,” according to WisdomTree.
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