Using Bond ETFs To Hedge Against Fed Hikes

April 27, 2016

Bryce Doty is senior portfolio manager at Sit Investment Associates. He manages two bond mutual funds for the firm, as well as the Sit Rising Rate ETF (RISE), which came to market early last year. recently caught up with Doty to discuss the outlook for fixed-income markets ahead of today’s Fed decision. How many times do you see the Fed hiking rates this year?

Bryce Doty: One to two times. At this week's Fed meeting, you'll see this continued tug of war between the Fed governors who think that they should raise rates sooner rather than later, offset by the dovish stance of Janet Yellen.

There's going to be this back and forth, which will continually add volatility to both the stock and bond markets. Even with more Fed rate hikes presumably coming later this year, long-term Treasury yields remain low, with the 10-year bond yield below 2%. Do you see that changing at all?

Doty: No. If the Fed does nothing and you see inflation continue to creep higher, only then will you see 10- and 30-year yields rise, because they're the most worried about inflation.

On the other hand, the short end of the curve worries about Fed policy and what the current Fed funds target rate is.

If the Fed raises rates on the short end, that could actually keep yields low on the long end of the curve, thereby flattening the curve. That makes sense because it shows the market that the Fed is not asleep at the switch as it pertains to rising inflation trends. A big story earlier this year was the volatility in credit spreads. They blew out in January and now they've come back in. Do you have any thoughts on that?

Doty: It was a flight to quality. You have all these indexed-bond ETFs, which have a significant component of energy. If you're in an index fund rather than a managed bond portfolio and you want to get out of the way of the energy freight train coming right at you, you have to sell the whole index.

That selling drove spreads out across the board―which is a new phenomenon that we're feeling from ETFs.

Once people were able to get away from the energy debacle, they stopped selling and readjusted their weightings and portfolios accordingly, and that allowed spreads to snap back on companies that were being thrown out with the bathwater.

You had a lot of companies whose spreads widened, even though their earnings were fine and nothing else had changed, other than this technical selling pressure from the high-yield index.

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