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Bond Strategies To Weather Rising Rates
Following its latest trend, the Consumer Price Index (CPI) rose year over year in November as oil and shelter remained elevated. With the inauguration of Donald Trump this month, more inflationary pressures are expected in the near-term as expansionary fiscal policies are implemented over the next several years.
However, we expect these pressures to be met by counteractive U.S. Federal Reserve (Fed) policies. This environment will be tough for fixed income investors who already endured a record bond market sell off. Navigating through the next several years will no doubt be a challenge for fixed income investors, however, there are several strategies that could prove beneficial in mitigating risk in such an environment.
While yields could move slightly higher from their current levels, it is more likely that a new range has been established for 2017 with risks elevating as the Trump administration’s policies begin to have an impact. We expect to see increased inflationary pressures over the next several years, though the bond market is generally quick to price in risk, thus rewarding those early to the table. Fortunately, there is some solace for bond investors given the Fed’s mandate to contain inflation, and, therefore, we expect some support from monetary policy.
The success of the Fed in thwarting inflation will be the wild card for bonds. As most economic slowdowns and recessions have historically been caused by a Fed tightening cycle, it would be expected at a minimum that the Fed’s counteractive policy should keep pressures contained in an expansionary fiscal setting. Nonetheless, risks remain as the Fed cannot control inflationary pressures from global demand for commodities, oil prices and production agreements, or the overall demand for U.S. Treasury Securities to name a few.
Income oriented investors will need to be prepared for a series of short rate hikes in 2017 with potential risks from inflationary pressures over the next few years. Depending on the risk tolerance, there are several options which can help mitigate potential risks from rising rates and hopefully provide better results to the downside than the overall market.
|ETF Option||Style||Q4 2016||vs. Barclays Agg|
|Pimco Total Return ETF (BOND)||Active Management||(2.15%)||+0.83%|
|First Trust Low Duration Mortgage (LMBS)||Active Management||0.25%||+3.23%|
|SPDR Barclays Floating Rate (FLRN)||Floating Rate||0.38%||+3.36%|
|PowerShares Variable Rate Preferred (VRP)||Floating Rate||(2.48%)||+0.50%|
|iShares iBoxx High Yield (HYG)||High Yield Bonds||1.26%||+4.24%|
|Vaneck Vectors Fallen Angel High Yield (ANGL)||High Yield Bonds||1.79%||+4.77%|
|Powershares CEF Composite (PCEF)||Diversified Income||0.32%||+3.30%|
|First Trust Strategic Income (FDIV)||Diversified Income||(0.16%)||+2.82%|
Source: Zephyr & Associates, Inc.
Actively managed ETFs can be beneficial as the management team can adjust the portfolio’s duration and other exposures to adapt to market conditions or represent their view on the future path of interest rates. This allows talented management teams to navigate through difficult market environments and potentially mitigate downside risks through their investment process.
Floating rate strategies provide protection and may even benefit over time as the Fed raises rates, thus increasing the coupon or dividend income. Unlike fixed rate, floating rate securities adjust on a periodic basis along with an index rate. This keeps the coupon on the securities around current market levels and, therefore, they do not have to fall in value to the degree a fixed rate security would to keep the yield in line with the market.
With the Trump administration’s fiscal policy potentially spurring economic growth, equity sensitive securities, such as high yield bonds, should benefit as risk premiums come down. A boost from narrowing risk spreads (the amount of yield over like duration Treasury bonds required by the market) would potentially work to help lessen any spike in interest rates from inflationary pressures.
Finally, diversified income strategies provide exposure to income producing asset classes in addition to bonds. Dividend paying equities, REITs, and MLPs are examples of securities found in many of these strategies. While some of these asset classes tend to have some interest rate sensitivity, there is also a degree of equity sensitivity offering some diversification.
As we gear up for the New Year and a changing landscape, we expect to face volatility as we work to find clarity on how the new administration’s policies will impact the economy. The Fed’s ability to keep inflationary pressures contained in this environment will be crucial for bond investors moving forward. Strategies with features that have the ability to offer some support in a rising rate environment and diversification should prove beneficial in mitigating interest rate risk.
At the time of writing, Stringer Asset Management held LMBS, VRP, ANGL and PCEF among its universe of ETFs included in its suite of ETF Portfolios. SAM is a Memphis, Tennessee third-party investment manager and ETF strategist. Contact SAM at 901-800-2956 or at [email protected]. For a complete list of relevant disclosures, please click here.
The views expressed herein are exclusively those of Stringer Asset Management LLC (SAM), and are not meant as investment advice and are subject to change. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice. This material does not constitute any representation as to the suitability or appropriateness of any security, financial product or instrument. SAM is not making any comment as to the suitability of any funds mentioned, or any investment product for use in any portfolio. There is no guarantee that investment in any program or strategy discussed herein will be profitable or will not incur loss. This information is prepared for general information only. Investors should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that security values may fluctuate and that each security’s price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not a guide to future performance.
About the Author: Kim Escue
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