Using Momentum to Capitalize on Market Trends
It may seem paradoxical at first glance, but bond investors can often do well in a period of gradually rising interest rates. The reason is straightforward: the benefits of compounding through the reinvestment of interest payments can outweigh the loss of principle.
As noted in an earlier post, interest rates as measured by the 10-year Treasury have generally been in decline for the better part of three decades. Bond prices, of course, went up as rates fell. Anyone reinvesting their interest payments over that period has essentially been dollar cost averaging up—the bonds they bought were more expensive and interest payments fell. This was masked, in part, by capital appreciation—in particular, Treasurys have done well on a total return basis for many years, including this one, even as the Federal Funds rate approached zero.
A second challenge for bond investors over this period has been pre-payment—as rates fell, debt issuers often opted to pay off older, higher yielding debt with new issues sporting lower coupons. That hurt both capital appreciation and income.
In a rising rate environment (if we are in one), many of these dynamics start to reverse. Prices go down, but yields go up. Dollars reinvested can go back in at the lower cost basis and provide higher income. Pre-payment risk drops off. Benefiting from this shift requires a few things: first, that interest rate rise must be gradual and sustained; and second, most, if not all, of the income generated off the bond portfolio has to be reinvested.
This strategy may be further enhanced by employing a momentum investing approach to fixed income—moving the portfolio toward areas of relative strength based on the demonstrated persistence of asset price trends. The idea is that the benefits of fixed income momentum are not dependent on the overall direction of the bond markets—in other words, it should continue to perform as designed in both falling and rising rate environments. So while rising interest rates can potentially be disruptive to a fixed income portfolio, long term investors have the potential to benefit in multiple ways—by cost-averaging down and overweighting those areas of the bond market expected to outperform based on momentum.
As with all investments, there are certain risks of investing in the Funds. The Funds’ shares will change in value and you could lose money by investing in the Funds. The Funds’ investment performance, because they are fund of funds, depends on the investment performance of the ETPs in which they invest.
Funds that invest in bonds are subject to interest rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner.
The principal risk of mortgage-backed securities is that the underlying debt may be prepaid ahead of schedule if interest rates fall, thereby reducing the value of the Funds’ investment. If interest rates rise, less of the debt may be prepaid and the Funds may lose money.
The value of the Funds’ investment in ETPs is based on stock market prices and the Funds could lose money due to stock market developments, the failure of an active trading market to develop, or exchange trading halts or de-listings.
As new funds, there can be no assurance that they will grow to or maintain an economically viable size, in which case they may experience greater tracking error to its Underlying Indexes than they otherwise would at higher asset levels, or they could ultimately liquidate.
Smart beta defines a set of investment strategies that emphasize the use of alternative index construction rules to traditional market capitalization based indices.
Consider the Funds’ investment objectives, risks, and charges and expenses carefully before investing. The prospectus and the statement of additional information include this and other relevant information about the Funds and are available by visiting IQetfs.com or calling 888-934-0777. Read the prospectus carefully before investing.
MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the IQ Hedge Multi-Strategy Plus Fund. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.