Global central banks
As below, global Central Banks are flooding the financial system with liquidity or cash in order to support economic growth. The U.S. Federal Reserve, Japan ECB, and Bank of England have added nearly $6 trillion to the global financial system since 2008, with total assets rising from pre-crisis levels of $3.8 trillion to closer to $9.8 trillion today. Important to note in the below graph is the yellow line, which is GDP growth divided by M2 growth. M2, otherwise known as “the monetary base,” which consists of currency in circulation and reserve balances (deposits held by banks and other depository institutions in their accounts at the Federal Reserve Bank). M2 includes savings deposits, time deposits under $100,000, and retail money market shares.
This article considers the growth in global central bank asset purchases and the implications for fixed income investors. For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
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Source: Courtesy of Cumberland Advisors
The Central Bank focus: The declining yellow line
The declining yellow line reflects a decline in “money velocity.” As M2 increases (the denominator) in conjunction with Central Bank asset purchases, and GDP (the numerator) has remained relatively flat since 2008, we see that the velocity of money has decreased. In other words, there is more money in the financial system relative to GDP growth, and that these monies have not been taken out of the financial system for uses in investment. It is hoped that, in the future, this money in the financial system will make its way into investments and other uses, which are more conducive to economic growth, such as investment.
To see how lower credit quality and shorter duration fixed income ETFs compare to higher credit quality and longer duration ETFs, please see the next article in this series.
For additional longer-duration alternatives to LQD and AGG, please see the series on fixed income ETFs Key strategy: Will deflation contain the bear market in bonds?
Short duration, higher credit risk: SNLN & BKLN
If investors are concerned about a rising rate environment, they may wish to consider short-duration fixed income exposure through short-duration fixed income ETFs such as the Highland/iBoxx Senior Loan ETF (SNLN). This ETF holds senior bank loans, which offer a floating rate coupon based on short-term interest rate pricing—typically the 90-day interbank rate, known as “three-month LIBOR.” (LIBOR stands for the “London Interbank Offer Rate on Deposits,” and it’s established daily through a consortium of banks under the British Banker’s Association in London.)
Similarly, the Invesco PowerShares Senior Loan Portfolio ETF (BKLN) also holds senior bank loans and also has a short duration. The duration of these “floating-rate” loans is typically 40 to 60 days—much shorter duration than the typical four-year duration associated with similar corporate five-year bond portfolios. The loan portfolios also carry an additional advantage over longer-duration corporate bonds in that they have a much higher average recovery of loss rate compared to corporate bonds—closer to 80% compared to closer to 50% in the case of similar rated bonds.
It’s important to note that both these ETFs invest in loans that are rated in the BBB-B area and involve more risk of loss than portfolios rated in the AAA-A area. However, what they lack in credit rating they tend to compensate for in terms of higher returns. SNLN offers a yield-to-maturity of around 4.8%, and BKLN around 4.95%.
Longer-duration, lower-credit-risk alternatives: AGG & LQD
If you’re wary of credit risk, you could also consider longer-duration ETFs such as the iShares Core Total U.S. Bond Market ETF (AGG). It maintains a duration of 5.11 years, though it has a yield-to-maturity of 2.14%, as it holds roughly 70% of its portfolio in AAA and AA rated bonds. Similarly, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) offers a duration of 7.49 years and a 3.35 yield-to-maturity, and it holds the majority of its bonds in the A to BBB category. Like LQD, AGG also holds high-quality commercial credits, such as Verizon (VZ)(0.09%) and GE Corporation (GE)(0.08%). Like SNLN, BKLN also holds lower-rated commercial credits, such as Fortescue Metals Group (FMG)(1.96%) and Valeant Pharmaceuticals (VRX)(1.48%). Note that the individual holdings of BKLN and SNLN are much larger than the holdings of the higher-credit-quality holdings of LQG and AGG, reflecting the greater diversification and the lower level of default-related losses associated with AGG and LQD.