Investing In Bond ETFs As Rates Rise

September 26, 2018

Josh JenkinsJosh Jenkins is senior portfolio manager and co-director of research for CLS Investments. He is the portfolio manager of two conservative allocation mutual funds of ETFs, a money market fund, and a series of multi-asset income-focused separately managed accounts, which also use ETFs. recently spoke with Jenkins to discuss the latest developments in the fixed-income markets, including where rates are headed and how investors should position themselves in the current environment. The Fed is poised to hike rates this week and perhaps again in December. How many more hikes do you see the Fed making this cycle? Is there a terminal rate it’s aiming for before it stops hiking?

Josh Jenkins: We look at the dots that they publish with their expectations. What they see as the terminal rate is the best guidepost for our view. Right now, the Fed is projecting the midterm or long-term rate as between 2.75% and 3%. Four more hikes would get us there.

The market is expecting two more hikes this year, one in September and one in December. That’s consistent with what we expect.
The Fed is actually pointing to three hikes for 2019. Our view would probably be a little bit less than that, maybe two hikes, which is a little bit more in line with the market. Before the financial crisis, rates topped out around 5%. Why do you think the ceiling for rates is lower this time around?

Jenkins: There’s been a lot of discussion around demographics being a challenge, but I’d say a lot of it boils down to the fact that the recovery has been very slow. That’s kept a lid on long-term rates, at least for the time being. We’ve seen a much bigger move higher in yields on shorter maturities than longer maturities this year, which has translated into a flattening of the yield curve. Is that something you expect that will continue?

Jenkins: To us, that is one of the biggest, most important questions. The yield-curve inversion has been essentially a perfect indicator of recessions over the last 50-60 years. It would seem unwise to aggressively hike and intentionally invert the curve.

We’re concerned about that. I don’t think it’s lost its predictive power. We believe the short end is going to continue to move up. The question is, what’s going to happen to the long end? 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?

We’re not trying to make that call. We’re in a wait-and-see approach, and we’re trying to prepare portfolios regardless of what happens. How should investors position themselves in this current environment, where it seems like short-term yields are going to continue to move up, but the trajectory of long-term yields is more uncertain?

Jenkins: Out view relates to a long-term investor. Our view is that, regardless of what's happening to long-term interest rates, you want high-quality duration in your portfolio to offset equity risk.
Historically, there’s been a negative correlation between stocks and bonds. We think that holds today. 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.

The stock market is pretty richly priced. We’re not calling for a recession, but we think, this late in the cycle, one could definitely happen. We’re more concerned with balancing risk in an entire portfolio than being focused specifically within the bond portfolio.

The wonderful thing about rising rates is that the three-month T-bill is now paying 2.18%, the highest in 10 years. 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.

But we take a holistic view. We really want to manage what we feel is the biggest risk in a diversified portfolio, and that risk is not lying on the bond side. How is the corporate debt sector, including investment-grade and high-yield, looking to you? Is it worth taking credit risk in this environment?

Jenkins: On the high-yield side, no. If you look at credit spreads, they’re just a little bit above 3%. It’s essentially the most compressed it's been since 2007. We don’t feel like you’re getting paid to take credit risks, at least on the high-yield side.

On the investment-grade side, it also looks expensive, but not nearly to the same degree. We have some concerns around the lower-quality end of the investment-grade side. The proportion of the investment-grade market that’s in triple B’s is dramatically higher than it’s been historically. By a lot of metrics, it’s also lower quality than it’s been historically.

Still, right now, we’re carrying a decent amount of investment-grade credit risk, whereas we dramatically reduced high-yield credit risk over the last year or so. Emerging markets have been hammered across the board. Do you see any value in either local or dollar-denominated EM debt?

Jenkins: Coming into the year, it was looking pretty expensive. We had a heavy exposure in EM debt last year, but we reduced that pretty dramatically at the end of the year.
It’s getting to the point where it’s starting to look interesting, but it’s not an area of high conviction for us. We may have added a little bit of exposure there, but we haven’t made any big moves. What specific ETFs do you hold in the fixed-income space?

Jenkins: We’re sort of barbelling duration a little bit for our portfolios. We like some of the ultra-short and floating-rate ETFs like the PIMCO Enhanced Short Maturity Active ETF (MINT) and the SPDR Bloomberg Barclays Investment Grade Floating Rate ETF (FLRN).

We also like high-quality duration to help offset some of the equity exposure. It could be something simple like an iShares 7-10 Year Treasury Bond ETF (IEF), some longer-duration Treasuries or TIPS.

A lot of our portfolios have been migrating toward actively managed core holdings. That gives us the ability to benefit from security selection. You have deep credit benches at some of these firms.
We’re using funds like the SPDR DoubleLine Total Return Tactical ETF (TOTL), the First Trust TCW Opportunistic Fixed Income ETF (FIXD) and the PIMCO Active Bond ETF (BOND) pretty extensively in portfolios. What general piece of advice would you give fixed-income investors headed into the final quarter of the year?

Jenkins: One of the ways we try to ease people’s minds is by just reminding them that when interest rates are rising in the short term, it definitely hurts, and you can see some unrealized losses. 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.

When rates were effectively at zero, you weren’t clipping much of a coupon. But as there is an orderly move toward normalization, for savers in the long term, that is a benefit. It’s not necessarily something that people should be fearing.

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

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