Why Go Short?
Bond returns are primarily a function of two things: interest rates and duration. Interest rates are intended to reflect the cost of money, adjusted for credit risk and other factors. They go up and down based on economic conditions and, as we all know, the actions of the Federal Reserve, among other factors.
Duration is a little more abstract. It’s defined as the sensitivity of the price of a bond to changes in interest rates. But the word “duration” suggests the passage of time and that sensitivity is correlated to the term of the loan – the point in the future at which the bonds must be paid off and the money returned to the lender. It’s generally assumed that the longer that time the greater the risk, and, as a result, the greater the sensitivity to changes in interest rates.
If you hold to maturity, the date on which the bond comes due – and there’s no intervening credit event – then you get your money back plus all the interest you earned along the way. In the meantime, bond prices can be volatile and, if you need to sell for any reason, you may or may not get back the face value of the bonds. And, of course, there’s the emotional stress of watching the value of an investment go up and down.
For that reason, many investors have turned to short-duration bonds to generate income while providing some protection against market volatility. Short-duration funds tend to be especially attractive during periods of rising interest rates, because as the name suggests, their “duration” or sensitivity to changes in interest rates is limited. Rising interest rates can have a negative impact on the value of the underlying securities since bond prices go down when rates go up and vice versa. And while the Fed has most recently signaled a slowdown in rate increases, the Fed funds rate has mostly been going up over the last 3 years– rising from zero in the wake of the Financial Crisis to a current range of 2.25 – 2.50%1. Yields on treasuries and corporate debt have moved up as well, increasing the income available to investors at the short end of the yield curve.
In early February, two-year U.S. Treasuries were trading to yield a little over 2.5%2. As of January 31, 2019, investment grade corporates3 with a similar duration are yielding around 3.27% and short-term high yield bonds4 carried a yield of around 6.96% for those rated BBB or worse. A portfolio that combines these assets can provide an attractive return while managing for volatility. In an ETF, that return can potentially be improved by using a factor-based approach to the index construction process.
As we have noted before in this recent blog, with other bond instruments, one factor that has shown the ability to add value over time is momentum. By including a momentum screen in the index construction process we can overweight and underweight various sectors of the investment grade floating rate, short-term Treasury, investment grade and high yield markets, looking to move towards those that demonstrate the best return characteristics. This, in turn, can potentially lead to outperformance versus the index.
Like all investing, bonds are a risk/return calculation. With a relatively flat yield curve at the moment, investors who “go short” give up a small amount of yield while managing duration risk. It’s a trade worth considering.
SDAG, IQ Short Duration Enhanced Core Bond U.S. ETF, was recently nominated for two 2018 ETF.com Awards:Best New U.S. Fixed Income ETF and Best New Smart Beta or Factor ETF
1. Source: Federal Open Market Committee, as of February 7, 2019.
2. Source: wwww.treasury.gov.
3. As represented by the Bloomberg Barclays U.S. Corporate 1-5Y Total Return Index. Past performance is not a guarantee of future results. It is not possible to invest directly in an index.
4. As represented by the Bloomberg Barclays U.S. High Yield 350M Cash Pay 0-5Y 2% Cap Total Return Index. Past performance is not a guarantee of future results. It is not possible to invest directly in an index.
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The Financial Crisis of 2007–2008, also known as the global financial crisis, began in 2007 with a crisis in the subprime mortgage market in the United States, and developed into a full-blown international banking crisis with the collapse of the investment bank Lehman Brothers on September 15, 2008.
U.S. Treasuries are backed by the full faith and credit of the United States government as to payment of principal and interest if held to maturity.
The Bloomberg Barclays U.S. Corporate 1-5Y Total Return Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by US and non-US industrial, utility and financial issuers.
The Bloomberg Barclays U.S. High Yield 350M Cash Pay 0-5Y 2% Cap Total Return Index measures the market of USD denominated, noninvestment-grade, fixed-rate, taxable corporate bonds. The index limits the exposure of each issuer to 2% of the total market value and redistributes any excess market value index-wide on a pro-rata basis.
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