Fixed income ETFs and Treasuries
The below graph reflects changes in popular fixed income ETFs since the 2008 crisis. As the bond market rally has softened and interest rates have risen, longer-duration bonds, as reflected in the iShares Core Total U.S. Bond Market ETF (AGG) (duration of 5.11 years) and iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)(duration of 7.49 years) have weakened. In contrast, shorter-duration bond funds, such as the Highland/iBoxx Senior Loan ETF (SNLN) and Invesco PowerShares Senior Loan portfolio ETF (BKLN), with durations under 60 days, have maintained their price levels.
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.
The sudden rise in the seven-year Treasury yields, which doubled from 1.20% in April 2013 to 2.40% in September 2013, meant that longer-dated bonds and longer-dated bond-holding ETFs, such as AGG (5.11 years) and LQD (7.49 years), incurred significant duration exposure–related losses, with the 7.49-year-duration LQD dropping 8.00% in value in seven months. While the high-quality credit in LQD may seem attractive relative to the lower-quality credit exposure in SNLN and BKLN, the above graph demonstrates the significant risk posed by long duration risk in a rising rate environment.
Credit quality risk
Plus, as the above graph illustrates, the small declines in both SNLN & BKLN, with virtually no duration exposure, can often maintain their value in a rising rate environment, as the yield premium associated with the ETF bond holdings may not always change that much in conjunction with government interest rates. However, the inverse is also possible. In a persistently soft economic environment, it’s also possible that government and other high-rated credit yields may not change that much, and that credit spreads associated with lower rated bank loans found in SNLN and BKLN could underperform as corporations see cash flow decline and their ability to service their debt is compromised. For further analysis of this issue, please see the Market Realist analysis by Dale Norton The difference between High Yield Bond ETFs and Investment Grade Bond ETFs.
To see how fixed income ETF investors can hedge their duration risk attributed to rising interest rates with other fixed income ETFs, please see the next article in this series.
For additional longer-duration alternatives to LQD and AGG, please see 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 that offer a floating rate coupon based on short-term interest rate pricing, which is 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 similarly rated bonds.
It’s important to note that both of these ETFs invest in loans rated in the BBB-B area, and they do 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
Should investors be wary of the credit risk, they could also consider longer-duration ETFs such as the iShares Core Total U.S. Bond Market ETF (AGG), which maintains a duration of 5.11 years though 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. LDQ includes higher commercial credits such as Verizon (VZ)(0.70%) and Blackrock Funds (BLK)(0.67%), whereas SNLN holds lower-rated commercial credits such as Caesar’s Entertainment (CZR)(2.35%) and Hudson’s Bay Company (HBC)(1.50%).