Outlook For Fixed Income ETFs

October 11, 2018

[This article appears in our November 2018 issue of ETFR Report.]

 

Fixed-income fever has taken over financial markets again. After a brief lull during the summer months, U.S. Treasury yields are back to hitting new highs, sending reverberations through investors’ portfolios.

As of this writing on Oct. 9, the 10-year Treasury yield had just hit a fresh seven-year high of 3.26%, while the 30-year Treasury yield touched a four-year high of 3.45%.

With Federal Reserve Chairman Jerome Powell recently commenting that the central bank was a “long way” from its neutral policy rate—the interest rate that’s neither restrictive nor stimulative for the economy—investors are wondering whether yields can spike even more from here, and if so, what they should do about it.

 

US 10-Year Treasury Bond Yield

 

Fed Rate Path

One of the keys to determining where rates end up during this cycle is what the Federal Reserve does with its benchmark overnight interest rate, the federal funds rate. The latest Fed dot plot, which contains forecasts for where central bank officials see the trajectory of the fed funds rate, suggests that another hike is nearly certain this December.

After that, the Fed anticipates it’ll hike another three times in 2019, potentially bringing its target rate up from 2-2.25% currently to 3-3.25%—a range many officials believe is close to the neutral rate.

For investors just getting used to higher interest rates, four hikes between now and the end of next year is quite a lot to swallow, but not necessarily hard to justify. The latest economic data has been stellar. The unemployment rate dropped to a 49-year low, and the ISM non-manufacturing index jumped to an all-time high in September.

The booming economy puts pressure on the Fed to continue raising interest rates to prevent accelerating inflation. On the other hand, if, for whatever reason, the economy cools off, the Fed may slow its rate-hiking pace.

Rate hikes are “dependent on continued job growth and inflation. The Fed does not set trends, it follows them,” said Andy Martin, president of 7Twelve Advisors.

The Big Question

While most analysts agree that Fed rate hikes will likely put upward pressure on short-term bond yields, they’re less certain about the long end.

Though 10- and 30-year Treasury bond yields have recently broken out to new multiyear highs, for the year as a whole, they’ve lagged shorter maturities, resulting in a flattening of the yield curve.

For instance, the 10-year yield rallied from 2.4% to 3.2%, or 0.8%, between the start of the year and Oct. 9, but the two-year yield leapt from 1.88% to 2.88%, or 1% in the same period.

 

US 10-Year vs 2-Year Spread

 

 

Investors are concerned that if short-term yields keep rising, long-term yields may not keep pace, resulting in an inverted yield curve, where short maturities yield more than long maturities.

Josh Jenkins, senior portfolio manager and co-director of research for CLS Investments, says whether the yield curve inverts or not is one of the biggest, most important questions facing financial markets.

“We believe the short end is going to continue to move up. The question is, what’s going to happen to the long end?” he asked. “Are our growth and inflation expectations going to pick up and continue to boost the long end? Or are we going to see the inversion?”

Mixed Views

Survey the investment community and you’re unlikely to find a consensus answer to that question. Jeffrey Gundlach, the outspoken CEO of DoubleLine Capital, predicts that the 30-year bond yield will go significantly higher, perhaps to 6% in the next few years.

On the other hand, Gary Stringer, president and chief investment officer of Stringer Asset Management, thinks most of the upside move is over.

“The market for long-term interest rates is a global market, and the spread between the 10-year Treasury and similar debt issues from the likes of Germany and Japan are quite wide by historical comparison,” he said. “Unless the U.S. economy keeps growing at or above its recent strong pace and foreign interest rates move higher, it would be hard for U.S. long-term interest rates to push higher from here.”

Consider Duration

Regardless of what happens with long-term rates, CLS’ Jenkins recommends that investors should have high-quality duration in their portfolio to offset equity risk.

“Historically, there’s been a negative correlation between stocks and bonds. We think that holds today,” he remarked. “As rates creep up, you might have, in the near term, some small losses in your bond portfolio. But that’s dwarfed by the potential loss that could manifest itself in an equity portfolio.”

Investors who don’t want to take the potential lumps that come with investing in long-term bonds while rates are rising can focus on shorter maturities, which are less interest-rate-sensitive.

“The wonderful thing about rising rates is that the three-month T-bill is now paying 2.18%, the highest in 10 years,” Jenkins said. “That’s a real return; it’s more than what the S&P 500 dividend yield is. If investors out there are really scared, they can shorten duration as a way to protect themselves.”

Avoid These Areas

Among the experts we spoke to, there’s broad agreement that short-duration ETFs, like the PIMCO Enhanced Short Maturity Active ETF (MINT) and the Janus Henderson Short Duration Income ETF (VNLA), were a good value, with rates well off their bottoms.

Floating-rate ETFs, whose coupon payments adjust based on prevailing market interest rates, are also recommended for investors concerned about rates heading even higher. Examples include the SPDR Bloomberg Barclays Investment Grade Floating Rate ETF (FLRN) and the SPDR Blackstone / GSO Senior Loan ETF (SRLN).

On the flip side, there’s consensus to stay away from high-yield bond ETFs. With the yield premium for corporate high-yield bonds over Treasuries recently hitting 11-year lows, experts agree that investors aren’t getting adequately compensated for the much higher risk that junk bonds possess.

They also agree that emerging market bonds, while down notably this year, are still too risky to buy.

“There are too many uncertainties with emerging market debt for us to be interested at this point,” cautioned Stringer. “We view the fixed-income portion of our portfolios as a stabilizer, used to generate current income and offset equity risk. Buying emerging market debt at this point brings in too much risk of its own, in our view.”

Don’t Fear Rising Rates

Rising rates bring challenges as well as opportunities. But the experts agree: All else equal, higher interest rates are a good thing for investors, as greater yields equal greater future returns. That’s a much better situation for most fixed-income investors than when rates stood at rock-bottom levels only a few years ago.

“When interest rates are rising in the short term, it definitely hurts, and you can see some unrealized losses,” Jenkins concluded. “But at the end of the day, the income you're collecting is going to be one of the big drivers of your future returns. When those yields are rising, over the long term and moving forward, that’s actually going to help your bond portfolios; it’s not something people should be fearing.”

Email Sumit Roy at [email protected] or follow him on Twitter sumitroy2

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