Using Smart Beta ETFs In Fixed Income

September 05, 2017

Kevin FlanaganKevin Flanagan is senior fixed-income strategist at WisdomTree. ETF.com spoke with him recently about the inroads smart-beta strategies are making in the fixed-income space.

ETF.com: This year has been a surprise when it comes to interest rates. A lot of people were predicting bond yields to climb, yet the 10-year Treasury rate is down about 0.30% points on the year. Do you think rates will ever rise above 3% on a sustained basis during this cycle?

Kevin Flanagan: I don't think you're going to see that type of movement any time soon. Our current trading range for the 10-year for the second half of 2017 is in the 2-2.75% band.

The market priced itself for events that hadn't taken place yet—the Trump reflation trade for instance. The lack of progress on the fiscal-policy front in Washington, D.C., combined with some pullback in inflation readings, has changed the dynamic for the backend of the Treasury curve.

ETF.com: Do you think what's transpired this year should change how investors position their fixed-income portfolios? A lot of people were hedging against higher rates going into the year.

Flanagan: One of the strategies we've been suggesting is to take a core approach to fixed income and then combine that with a short duration or even a zero-duration strategy.

That type of a blend makes sense. We can make the case that if you do get some progress in Washington—and it doesn't need to be tax reform, just, say, tax cuts—then the Fed could potentially raise rates one more time this year. That's something the market isn’t priced for at all at this point in time.

As a matter of fact, if you look out to next year for fed funds futures, you're barely at 50% that the Fed is going to raise rates again in March or May of next year.

It also looks like the Fed's going to begin the process of normalizing its balance sheet. If you were to get these forces back into play, we wouldn't be surprised if you saw the 10-year trading above 2.5% again.

I don't have a definitive or aggressive call that rates are going higher, but I think some hedge—given where rates have fallen back to—still makes sense in this environment.

ETF.com: Based on that outlook, which products do you recommend?

Flanagan: We have some zero-duration strategies we like to blend with our core product, which is the WisdomTree Barclays Yield Enhanced U.S. Aggregate Bond Fund (AGGY). That's our enhanced-yield ETF that reweights the allocations or sectors of the Barclays Agg.

We like to use that as our core holding and then either blend it with a zero-duration strategy or a short-duration strategy like the WisdomTree Barclays Yield Enhanced U.S. Short-Term Aggregate Bond ETF (SHAG).

If you were to focus on the AGGY and SHAG blend, you not only can bring duration in under what the current duration is for the Barclays Agg, you wind up picking up about 10 or 15 basis points extra in income. We think that represents a good strategy for fixed-income investors.

 

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