Bond markets have been front and center for investors this year.
A new Fed chairman, 10-year Treasury yields near 3%, and rising inflation are just three of the factors fixed-income investors have had to grapple with so far in 2018.
With the market in flux, ETF.com sat down with five fixed-income experts to get their take on where things are headed from here and how investors should position themselves in these turbulent times.
How should investors position themselves in the current rising interest rate environment?
Josh Jenkins, portfolio manager; Omaha-based CLS Investments
We think it’s important to remember bond investors are better off with higher rates. The current yield is a strong predictor of future bond returns, so higher yields today should improve returns tomorrow.
Investors and managers have a lot of tools at their disposal to dampen the impact of further rate increases. There are tons of options in the short-to-ultrashort bond ETF space to target a lower duration.
We like active management in the ultrashort space, including the PIMCO Enhanced Short Maturity Active ETF (MINT), the Janus Henderson Short Duration Income ETF (VNLA) and the PowerShares Variable Rate Investment Grade Portfolio (VRIG).
Bank loan ETFs, such as the PowerShares Senior Loan Portfolio (BKLN) and the SPDR Blackstone / GSO Senior Loan ETF (SRLN), which are typically floating rate, offer a way to shorten duration without sacrificing yield.
Investors can also introduce liquid alternatives to their portfolio to help diversify the equity risk. The JP Morgan Diversified Alternatives ETF (JPHF) is a name we like here.
Mike Arone, chief investment strategist; State Street Global Advisors
Rising interest rates, increasing inflation expectations, widening deficits and tighter monetary policy have deepened investors’ fears about the outlook for bonds. Growing interest rate and credit risks continue to far outweigh the paltry yields offered to bond investors.
Despite these worries, investors shouldn’t abandon bond allocations in an evolving rate environment. In today’s challenging fixed-income environment, I suggest investors consider a core, complement and cushion approach to their bond allocations. Selecting a strong, experienced, risk-focused active core manager may help portfolios better navigate this tough environment.
Investor portfolios are vastly overallocated to investment-grade corporate bonds and high-yield bonds. Given the credit risks investors are taking for the narrow rewards they’re receiving in these bond sectors, I suggest investors complement existing credit positions with senior loans.
This allocation enables investors to maintain credit exposure, capturing important yield, while moving up the capital structure, shortening duration and gaining access to a floating-rate investment.
Lastly, short-duration, investment-grade floating rate bonds should weather a rising rate environment more effectively than fixed rate bonds of similar maturities. Investment-grade floating-rate bonds help investors reduce interest rate risk, move up in credit quality and benefit from higher short-term interest rates.
Jerome Schneider, head of short-term portfolio management and funding; PIMCO
Investors should consider actively adapting their investments to embrace a rising rate environment in 2018 and beyond, as well as changing market dynamics such as a supply-and-demand mismatch and future regulatory changes. Investors in passive strategies are likely at a disadvantage when yields rise.
More importantly, the supply and demand imbalance as issuance increases could present a tremendous opportunity for investors looking to lower their portfolio risk and capture liquidity premiums in their portfolios.
Kevin Flanagan, senior fixed-income strategist; WisdomTree
Although rates along the U.S. Treasury yield curve have increased thus far in 2018, the past two years’ experience underscored the point that not all rates move in the same direction. Specifically, in 2017, despite the fact the Fed raised rates three times, the U.S. 10-year Treasury yield actually fell 3 basis points during the calendar year.
Given the Fed’s guidance and market outlook for additional increases in the Fed funds rate in 2018, if not beyond, some “Fed protection,” at a minimum, seems warranted. Against this backdrop, we feel investors using a floating-rate product may be better able to insulate their bond portfolio as compared to a more traditional defensive fixed-income investment.
Bob Smith, chief investment officer; Sage Advisory Services
We believe that an overweight to higher-yielding investment-grade spread sectors versus Treasuries will continues to offer marginally better returns, and that folks should abandon a full commitment to broad fixed-income-market positions such as the iShares Core U.S. Aggregate Bond ETF (AGG) and the Vanguard Total Bond Market ETF (BND) in the current and prospective market environment over the balance of this year.
Dis-aggregating the Aggregate bond index to look for subsectors (by duration and quality) within it that will do better in this environment is what investors should be doing. It is also important to note that interest rate and credit spread cycles are not synchronized, and often run in different measures and time frames. As such, a fear of rising rates, near or longer term, needs to be considered relative to those investment sectors that will be adversely affected in the early parts of a monetary tightening cycle.
History suggests that higher-yielding investment-grade spread sectors of the market do fine, provided you have the right defensive duration allocation expressed in those portfolio positions.
The rate of ascent in rates is very important to consider as well. The faster the change occurs, the harder it will be for the markets to adjust, a la 1994. We do not foresee such an outcome, and believe the move to higher short-term rates will be more measured and transparent, thus serving to help alleviate some of the market angst over these efforts by the Fed.