A change in trend?
The below graph reflects the mirror image of the return on long term bonds. The Pro Shares Short 20+ year ETF performs inversely with the 20+ year bonds. In other words, when interest rates fall, and bond investors see bond prices rise, this ETF does the opposite. The large decline in long term bond yields led to very large gains for fixed income investors. However, since last year, long-duration bonds have begun to give back some of those gains as rates have bounced off lows. This article considers the possibility of rising rates and the case for taking a bearish view on bond prices.
To gain a broader understanding of the other macroeconomic factors supporting the economic and investment-related views in this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
Investment recovers: Will interest rates rise?
As the above graph illustrates, the TBF ETF incurred major losses when bond markets rallied post-crisis. However, the gradual recovery, or at least bounce, from the 2012 low rates in the long end of the curve are signs that the trajectory could change. The Fed has begun to slow its purchase of bonds as the labor market recovery is fairly complete. Should the Fed continue to withdraw from supporting the bond market in the coming year, it is likely that the long end of the yield curve could rise.
Growth gains momentum, though inflation remains low
There are signs that we’ve seen the bottom for bond yields, and macroeconomic indicators seem to support the return to a more normal level for interest rates. The only caveat at this point is the elusive sign of inflation. It would seem that the slow-down in government spending and the Fed’s tapering should translate into higher interest rates. This has happened to some extent. The above graph reflects the gains from being short bonds since 2012. However, inflation remains too low, and as a result, real interest rates in the long end of the curve are really not that low by historical standards.
While the economic recovery, to include the recovery in investment, seems to be gathering momentum, the rise in interest rates in the longer end of the yield curve has been modest. Despite the Fed’s ongoing growth in bond purchases—currently exceeding $4 trillion and growing at $75 billion per month—the lack of inflation has kept yields from rising very far or very quickly. As a result, it may be prudent to establish a tactical short in the long end of the curve if inflation expectations can rise and investors are convinced that the current economic recovery will not backslide into low growth.
A note on fixed income ETFs
Investors should be aware that the inverse and leveraged products try to achieve their objective on a daily basis, and due to compounding of daily returns, the performance of the ETFs may diverge from the target return over extended periods–especially during volatile market conditions. Inverse and leveraged ETFs can be used as a portfolio hedge against market turns. However, there can be a significant variation in returns of fixed income ETFs such as TBF and the specific bonds that it seeks to replicate via a short position.
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—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 similar rated bonds.
It’s important to note that both these ETFs invest in loans that are rated in the BBB-B area and they 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. 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%).
For more information on ETFs please see, Fixed income ETFs: Short-duration alternatives for bonds.