Fresk: Bonds At A Crossroad

February 03, 2014

All of this begs the question, Is this time different? Via this analysis, the bear market we’ve seen over the past 17 months doesn’t look significantly different from previous bear markets.

Additionally, stepping back and looking at other asset classes, equities have rallied impressively in the past five years, and some market participants believe that market is now “overcooked” and a pullback in equities is a distinct possibility.

If that’s the case, could we see some flight-to-quality asset rotation back into fixed income, which could increase demand and drive rates lower once again?

Perhaps that’s exactly what we’re seeing as January draws to a close. The S&P 500 has traded more than 3 percent lower, and the yield on the 10-year Treasury note has retreated 30 basis points from the end of the year.

The counterpoint to this question is—very fairly—that this time is different. The current low level of rates might very well be unsustainable.

Additionally, we have factors—such as QE 1, 2 and 3 (quantitative easing—that have created “artificial: demand, and henceforth have instilled a ceiling on rates.

Therefore, as the Fed begins to taper purchases and we see a new chief in position, these may be the necessary catalysts to trigger a continuing rate-climb environment.

Positioning is this type of uncertain environment can prove problematic depending on what side of the higher-rates/lower-rates coin an advisor is on.

If you’re in the lower-rates camp, positioning is much easier, as the number of mid-to-long duration fixed-income ETFs is plentiful. One can step way out the curve into products such as the Pimco 25+ Year Zero Coupon ETF (ZROZ | C-51) or into something more simple/vanilla such as the iShares 7-10 Year Treasury ETF (IEF | A-49).

If you’re in the higher-rates camp and just wish to shorten the duration of your fixed-income holdings, nearly every one of the fixed-income sectors now has short-duration options available, including new funds such as the ProShares Short Term USD Emerging Markets Bond ETF (EMSH).

What may be of more interest to those who have more conviction in their higher-rates view is the new negative-duration ETFs offered by WisdomTree: the WisdomTree Barclays U.S. Aggregate Bond Negative Duration Fund (AGND) and the WisdomTree BofA Merrill Lynch High Yield Bond Negative Duration Fund (HYND). These funds combine a long position in standard index exposure along with short futures positions to generate the-negative duration exposure.

 

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