This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Larry Whistler, president and chief investment officer of Buffalo, New York-based Nottingham Advisors.
As the Federal Reserve embarks on its long-awaited interest rate “normalization” voyage, portfolio managers need to prepare their portfolios for the journey. As passengers on this ship, intended or not, bond holders everywhere will feel the sting of rising rates for the first time in nearly 10 years.
We’ve noticed a certain complacency having set in in the fixed-income arena, with few investors properly acknowledging that, indeed, one can lose money in bonds!
Five Big Bond ETFs
The largest fixed-income exchange-traded funds by assets are:
- Vanguard Total Bond Market ETF (BND | A-94), $26.9 billion in assets
- iShares Core U.S. Aggregate Bond ETF (AGG | A-98), $24.9 billion
- iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD | A-77), $20.7 billion
- Vanguard Short-Term Bond ETF (BSV | B-69), $16.1 billion
- iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-64), $14.1 billion
That’s more than $100 billon invested in those five ETFs alone. Although hardly identical, they all share one measure that investors should be focusing on right now: duration.
Duration, Up Close
A bond’s duration measures its price sensitivity to changes in interest rates. A bond with a duration of five years, for example, will suffer a 5 percent price decline should interest rates rise 1 percent. The same principle applies to fixed-income ETFs as well.
|U.S. Aggregate Bond (AGG)||3.26%||7.3||5.2||2.28%||1.9 MM||0.08|
|Vanguard Total Bond Market (BND)||3.30%||7.9||5.7||2.46%||2.1 MM||0.08|
|Vanguard Short-Term Bond (BSV)||1.90%||2.8||2.7||1.32%||889.3 K||0.10|
|iShares Investment Grade Corporate Bond (LQD)||4.26%||12.2||8.0||3.42%||3.2 MM||0.15|
|iShares High Yield Corporate Bond (HYG)||6.39%||4.9||4.2||5.37%||6.4 MM||0.50|
Source: Nottingham Advisors
As mentioned at the start of this post, it’s been nearly 10 years since the Fed raised the federal funds rate.
That said, we’ve had periodic interest rate spikes, but a longer, more sustained advance in interest rates hasn’t happened in over 30 years. Since the start of February, however, the 10-year U.S. Treasury note has seen its yield spike by 74 basis points—a 44 percent move higher!
A look at the chart below will give you an idea of how that move impacted the bonds in our sample set:
The Bond Investor’s Challenge
The trouble portfolio managers have had over the past few years has been to generate yield in a declining rate environment. Aside from levering up, the only other two ways to accomplish this are:
- taking on higher credit risk, or
- extending duration
Oftentimes, all three strategies—leverage; extra credit risk; and longer duration—will be employed to meet a specific yield mandate.
With interest rates still near historic lows, an investor’s return per unit of risk has declined meaningfully. As the chart below illustrates clearly with respect to the Barclays Agg, investors are accepting nearly three times the risk to achieve the same yield they could earn 20 years ago.
One way for fixed-income investors to prepare for this is by controlling for duration via target-maturity bond ETFs.
Target-Date Maturity ETFs
Both Guggenheim and iShares offer target-date bond ETFs that invest in investment-grade corporate bonds, high-yield bonds and municipal bonds. Investors get the liquidity, cost and diversification benefits of ETFs while knowing that their bond fund carries an “expiration date.”
This is in stark contrast to the perpetual nature of traditional fixed-income ETFs.
Bond ladders and barbells can easily be constructed using target-date ETFs. They can also help portfolio managers tilt a portfolio one way or another, either adding or subtracting duration from a core bond portfolio, depending on one’s view over the future direction of interest rates.
Guggenheim even offers a neat tool on its website for portfolio managers to easily model ETF portfolio characteristics—granted they use the BulletShares product. A link to this helpful tool can be found here.
Understanding the interest-rate sensitivity of one’s investment portfolio is important regardless of where interest rates are heading. With the Fed seemingly admittedly poised to initiate a rate-tightening cycle, it’s especially timely to know how one’s portfolio will react.
By taking advantage of the different ETFs and ETF provider tools available in the marketplace, professional and individual investors alike can more effectively manage interest-rate risk in their portfolios.
At the time of writing, Nottingham owned shares of AGG, BND, LQD, BSV, HYG as well of some BulletShares target-maturity bond funds. Nottingham Advisors is an ETF strategist that manages and advises on more than $1 billion in assets for advisors, institutions and individuals. Nottingham has been using ETFs since 2001 and currently offers five unique strategies with focuses on risk-based total return, current income and real return. To learn more, visit www.nottinghamadvisors.com or contact Nottingham directly at 716-633-3800. For all relevant disclosures, please go here.