5 Views On Fixed Income ETFs For 2018

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.

Where do you see interest rates heading?

Jenkins: We do not have strong conviction on rates right now.

The 10-year Treasury yield is up over 80 bps since last September, as the market has priced in the tax cuts, increasing supply of and decreasing demand for Treasuries, and the prospects of increasing growth and inflation.

In the intermediate to long term, our expectation is that the 10-year yield will continue to move higher, but will remain low by historical standards.

In the near term, we think the recent sell-off could be overdone.

Arone: The 10-year Treasury’s failure to break through the 3% threshold leads me to conclude that interest rates are likely to remain range bound for most of 2018. U.S. economic growth may be improving but remains stubbornly below the 3% milestone.

The market may have experienced an inflation scare in February, but with the recent average hourly earnings and core CPI data releases, it’s hard to argue the economy has an inflation problem. Combine that with the structural tail winds of aging U.S. demographics, the disinflationary impacts of technology and the growth dampening effects of debt on the economy, and rates are likely to remain well anchored.

Schneider: Six months ago, we believed interest rates were mispriced when the two-year Treasury note hovered around 1.25%. Now with the yield near 2.3%, we are closer to fair value. With a flatter yield and credit curves, the question for investors is, should they reach for additional duration (interest-rate exposure) or equity dividends, which are around 2%, to produce attractive returns?

Probably not. The sector has gone from an afterthought of cash management to a structural allocation for those fearful of volatility or higher rates in 2019 and beyond. Our view is that investors should consider being positioned to embrace higher rates in the U.S. during this course of time.

Flanagan: The bond market is beginning to think the Fed may raise rates more than the Fed projected. Three moves have been fully priced in the Fed funds futures market, and the conversation has turned to the possibility of a fourth tightening move in 2018 (one rate hike each quarter).

Barring any unforeseen events (e.g., geopolitical), it also appears likely the U.S. 10-year yield has moved into an elevated trading range, with the 3% threshold representing a key technical level.

Are there any areas of the fixed-income market where you see value or that you would avoid (including any specific ETFs)?

Jenkins: When we look at our portfolios, it’s easy to find exposures we’d like to trim. The problem is where to go. Yields remain low by historical standards, and despite recent volatility, credit spreads are very tight.

We’ve gradually been improving the quality of our portfolios. We’re big believers of active ETFs, and like some of the broad names, including the First Trust TCW Opportunistic Fixed Income ETF (FIXD), the SPDR DoubleLine Total Return Tactical ETF (TOTL), the Fidelity Total Bond ETF (FBND) and the PIMCO Active Bond ETF (BOND).

As the Fed continues its path of tightening, cash is becoming a real asset class again. We like some of the active names in the ultrashort bond space, including MINT, VNLA and VRIG. We also like the floating-rate structure of bank loans, including BKLN and SRLN.

Arone: The SPDR Bloomberg Barclays Investment Grade Floating Rate ETF (FLRN) is a compelling value. It seeks to track an index of short-term investment-grade floating-rate notes with coupons that adjust based on movements in short-term rates such as LIBOR.

As demand increases for short-duration solutions, investors may want to consider floating rate structures over fixed-coupon bonds. The majority of these securities are tied to the three-month London interbank offered rate (LIBOR) plus a predetermined spread.

The benefit of this structure is most pronounced as interest rates rise, because it reduces interest rate risk relative to fixed-rate bonds. LIBOR has increased by 95% since the start of 2017, and is at its highest level since late 2008.

As a result, the floating-rate index has outperformed its fixed-rate counterpart over the past year and year-to-date. With short-term interest rates poised to move higher, the outperformance of floating-rate notes may persist.

Flanagan: Many areas within the fixed-income universe appear to be fully valued. Credit spreads have narrowed to multiyear lows, and some market corrections should not be ruled out, but we feel that investment grade and high yield corporates could remain in a range-bound pattern. That being said, it will likely be difficult to replicate recent years’ performances.

Emerging market local debt has been the best performer in fixed income this year and continues to offer some moderate value from a “carry” perspective.

Smith: We are generally cautious, with durations a bit short versus the market, and we have reduced our allocations to U.S. high-yield debt.

We still have some exposure to the following areas: emerging market debt [iShares JP Morgan USD Emerging Markets Bond ETF (EMB)]; preferreds [iShares U.S. Preferred Stock ETF (PFF)]; senior bank loans [SPDR Blackstone / GSO Senior Loan ETF (SRLN)] and inflation-protected securities [iShares TIPS Bond ETF (TIP)].

We preferred these allocations because we believe rates are gradually headed higher under the influence of Fed monetary policy efforts, the yield curve will continue to be biased toward flattening, and economic activity will remain buoyant and positive, thus putting more pressure on inflation indicators.

Follow Sumit Roy on Twitter @sumitroy2