Solving real-world, fixed-income investor problems
Financial products exist, or should exist, for a very specific reason: to solve real-world investor problems. Those could be any number of things – generating absolute return, income, exposure to the growth potential of a region, a country, or an industry sector – to name a few.
“Solving Problems” was the theme of a recent panel at the “Inside Smart Beta & Active ETFs Summit” hosted by Inside ETFs. It was noted that in spite of the proliferation of ETFs, there are still opportunities to add value and solve problems for investors.
One of the biggest conundrums over the last few years has been how to generate income.
Neither of the two traditional approaches – adding duration to a portfolio by going long or adding risk by moving down in credit quality – have been particularly attractive over the last several years, with rates at historical lows, tight high yield spreads, and a relatively flat yield curve. Adding duration increases exposure to the impact of rising rates. For the first time in many years, that appears to be a real threat, with the Fed committed to raising the discount rate and yields on the 10-year Treasury recently pushing above 3%.
Increasing credit risk is no panacea, either. Spreads (high yield to the 10-year Treasury) are tight, around 300 basis points, compared to the historical average of about 535 basis points and a high of around 800 basis points.1 While a strengthening economy – and a coincident rise in interest rates – can be good for high yield, declining credit quality and increasing defaults could lead to a sell-off, and that, in turn, could be exacerbated by widening spreads.
So, those are the problems. What are the solutions?
Clearly, it involves moving away from just investing in the traditional aggregate bond indexes. One tool that has been demonstrated to add value in equities, and which is now being applied to fixed income as well, is momentum. In a bond ETF, momentum can be incorporated in the underlying index as a “factor” to be taken into account in constructing a portfolio (hence, the “smart beta” in the title of the conference).
In this approach, the index weights various fixed income sectors (short-term, intermediate, and long-term Treasurys, investment-grade corporate bonds, and investment-grade mortgage-backed securities, for example), overweighting sectors with high momentum and underweighting sectors with low momentum. Momentum is determined based on the average of that sector’s short-term total return, compared to the sector’s average total return index over a longer-term period, while also taking into account volatility.
The goal is to create a portfolio that gravitates towards the best-performing sectors of the bond market, all with similar levels of risk and high tax efficiency, while outperforming the investment-grade, U.S. taxable fixed income market.
In high yield, the issue is addressed a little differently since there are potential credit issues that don’t exist with Treasurys. Here, factors can be used to assess credit risk, relative to potential return, and to move the portfolio towards lower-risk, higher-rated, and more liquid bonds. Duration, too, can be taken into account as another “factor”. These considerations may help reduce the volatility associated with the riskiest credits, while continuing to capture a large portion of the yield.
Many investors today have never lived through a period of rising interest rates. While there may be no perfect solution for generating income and protecting principal in these circumstances, there are steps that can be taken to help mitigate some of the risk.
1. Sources: Bloomberg Barclays and IndexIQ Research, as of 4/30/18.
All investments are subject to market risk and will fluctuate in value. Alternative investments are speculative, entail substantial risk, and are not suitable for all clients. Alternative investments are intended for experienced and sophisticated investors who are willing to bear the high economic risks of the investment. Investments in absolute return strategies are not intended to outperform stocks and bonds during strong market rallies.
Hedge funds and hedge fund of funds can be highly volatile, carry substantial fees, and involve complex tax structures. Investments in these types of funds involve a high degree of risk, including loss of entire capital. Treasurys are backed by the full faith and credit of the federal government, as to the timely payment of principal and interest.
Smart beta defines a set of investment strategies that emphasize the use of alternative index construction rules to traditional market capitalization based indices.
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