5 Focus Areas For A Fixed Income Plan

May 13, 2016

Foreign Exchange

Through much of the first decade of the millennium, foreign-exchange impact was seen as simply a booster to international investment returns. Since the impact was positive for investors holding foreign bonds while being off the radar for investors holding only U.S. debt, many investors largely ignored foreign-exchange impact.

Over the last three years, foreign-exchange impact has been incredibly impactful. As the U.S. dollar (USD) skyrocketed, international investments were hit with a foreign-exchange haircut. So far in 2016, non-USD exposure has been a boost to returns.

While we take foreign-exchange risk on the equity side of our portfolios, we favor currency-hedged ETFs for broad-based fixed income. A popular currency-hedged international ETF is the Vanguard Total International Bond Index Fund (BNDX | B-57). Our decision to use currency-hedged ETFs was driven primarily by two things:

  • We don’t feel many investors can correctly forecast currency levels, especially in the short term
  • We don’t want foreign-exchange risk to dwarf the total risk spectrum of an investment

Given the current low rates on developed foreign bonds, the fluctuations from foreign exchange movements can easily decide more than 75% of an investment’s return. We feel more comfortable focusing on other factors.

In certain areas, such as emerging market debt, the cost to hedge currency risk is prohibitive. As these positions tend to have a higher yield, we currently feel comfortable taking currency risk in this area.

Rates

With interest rates throughout much of the world near historic lows, we feel it is important to look very closely at the impact interest-rate movements can have on a portfolio.

The easiest and most common way to measure interest-rate risk is through duration. While some investments—like TIPS—may require duration adjustment, we feel duration is a solid base measurement for monitoring interest-rate impact.

We tend to use the duration of the U.S. Aggregate Bond Index, which is currently 5.5, as a benchmark rate. We will then set our desired duration levels relative to the index level.

Given the low levels of current rates, we would encourage investors to pay close attention to rate impact. Likewise, it is important to make sure your portfolio is routinely run through a proven duration modeling exercise.

Spreads

In the current market environment, we tend to favor spread impact. We define spread impact as the impact different credit levels will have on portfolio results. For example, a portfolio with 50% high-yield bonds will typically have more spread impact than a portfolio with no high-yield bonds.

Of the five fixed-income aspects we focus on, spread impact is generally the one we feel we have the best opportunity to strategically manage risk over time.

Winning The Game

Sometimes it is the most complicated strategies that win the game. Other times, a simple approach can get the job done. Whatever type of strategy is employed, we feel strongly that understanding your strategy is an essential part to winning the game.

It is one thing to make a conscious decision to allow player #20 to shoot 3-pointers. It is a much less desirable situation to have no idea how good of a shooter #20 is until after they beat you from the 3-point line. We encourage investors to do proper scouting, understand their strategies, and execute with discipline and skill.

BNDX has been, may be and/or is currently held in several TOPS Portfolios. ValMark Advisers Inc. is the manager of the TOPS Portfolios of ETFs. ValMark started managing "TOPS" separately managed accounts of ETFs in 2002. The firm manages more than $5.1 billion in ETFs for retail and institutional clients in multiple investment products. Email: [email protected]; phone: 800-765-5201. For a complete list of relevant disclosures, please click here.

 

Find your next ETF

Reset All