When Duration and Credit Exposures No Longer Feel Like a Conservative Strategy

by: , Director, Product Management, IndexIQ

Traditional portfolios can typically be boiled down to aggressive versus conservative, as represented by stocks or bonds, respectively. With time on the investor’s side, the philosophy is to skew toward a more aggressive equity-leaning portfolio, and for those with less time or potential liquidity needs, to tilt toward a more conservative bond-leaning portfolio. The reason bonds are used as the conservative position is that investment-grade products typically have low default rates and produce income for investors, providing for a mostly reliable return expectation.

What Happens When Bonds Become Risky?

Bonds benefit as rates fall, since yields of older issues are more attractive than new issues priced at the lower rate after a rate drop. This situation raises the market price of the bonds issued prior to the rate drop, which the investor sees as additional return on top of the yield.

With Fed Funds rates at virtually at zero a few years ago, the bond market reached a precarious situation, where the only way ‘back to normal’ was a prolonged gradual increase in rates. As rates rise, the market prices of existing bonds fall, because the lower coupon rate is worth less.

A way to help mitigate the see-saw effect bond prices have with rates are bank loans, also referred to as floating rate loans. Typically, bank loans are issued with an adjustable rate, and therefore provide higher income to an investor as rates rise. The trade-off to participating in the rising rate environment is the assumption of credit risk as opposed to duration risk with traditional bonds, since the ratcheted higher rate on the debt instrument makes servicing the debt costlier. Interestingly, it is the perception of rates rising that causes the market to demand the floating rate exposure, ultimately resulting in prices rising due to that demand. When rates are no longer expected to rise, demand can dry up and have a negative consequence on price.

With the recent Fed minutes suggesting a pause in raising rates (as cited in the December 2018 meeting) and lowering expectations to potentially no rate hikes in 2019, the continued upward movement in rates is coming into question with the markets. The chart below, showing net flows to both mutual funds and ETFs in the Bank Loan category, reflects the fall in demand starting late in the 4th quarter of 2018:

Floating Rate Category Flow

Source: Morningstar, as of 3/31/2019.

Meanwhile, traditional bond exposures that suffer during rising rate periods, have provided mostly negative returns looking back to when the Fed first began raising rates in late 2016:

Fed Funds and Duration-based Exposure

Source: Morningstar, as of 3/31/2019.  Past performance is not a guarantee of future results. It is not possible to invest directly in an index.

With the return potential of the two primary bond return drivers (credit and duration) being called into question, it is worth considering other ways to provide conservative returns to a portfolio.

A Potential Solution

A merger arbitrage strategy is one potential solution.  For example, when a company is announced to be acquired, the target price of the acquisition serves as a terminal value for the stock, much like a par value of a bond. The target company in an acquisition can be best compared to a zero-coupon bond after the announcement, as the price of the equity typically reflects a discount to the target deal price.  The discount represents the investor’s potential return for assuming the risk of the deal potentially not completing successfully. (In the event the deal does not go through, it typically falls back to its pre-announcement trading range.) Unlike a zero coupon bond whose price is most closely tied to prevailing rates, the discount to deal price for an acquisition target is tied to the market’s pricing of the risk that the deal could fail to complete successfully.

Combining multiple deals at various stages of completion in a fund structure can help diversify the risk of an occasional deal failing, and provide an investor with the potential for a consistent stream of returns as the deals close.

While each deal can vary in length of time to completion, historically, the typical deal closes in about 120 days. This frequency suggests an average 300% turnover to be expected in a strategy that invests in announced deals, making tax-efficient fund structures, such as an ETF, desirable.

Observing the IQ Merger Arbitrage ETF (MNA) as an example, results exhibit a robust return with low volatility providing a conservative exposure that would act as an effective complement to bond allocations, without the exposure to credit or duration risk.

Evidence shows that a merger arbitrage exposure has a near zero correlation and significantly lower beta to traditional duration-based fixed income, yet provided the defensive benefits of low correlation and beta to equity markets:

5-Year MNA Statistics:

S&P 500 Index Bloomberg Barclays U.S. Aggregate Bond Index
Correlation 0.35 -0.12
Beta 0.11 -0.14

Source: Morningstar, as of 3/31/2019.

Risk mitigating measures such as low downside capture and low beta to equity markets are similar to bonds, yet the risk-adjusted returns tended to be more attractive, providing further evidence that a merger arbitrage strategy can serve as an effective low volatility piece of a well-diversified portfolio.

Down Capture Like Bonds, Sharpe Ratio like Equities

Source: Morningstar, as of 3/31/2019. Past performance is not a guarantee of future results. It is not possible to invest directly in an index.

With mixed outlooks for duration and credit risk, a low correlated strategy like merger arbitrage can be an effective way to complete the conservative portion of a portfolio.

Click on the fund name for the most current fund page, which includes, the prospectus,investment objectives, performance, risk, and other important information. Returns represent past performance which is no guarantee of future results. Current performance may be lower or higher. Investment return and principal value will fluctuate, and shares, when redeemed, may be worth more or less than their original cost. Visit nylinvestments.com/funds for the most recent month-end performance.

About risk

Before considering an investment in the Fund, you should understand that you could lose money. Certain of the proposed takeover transactions in which the Fund invests may be renegotiated, terminated or involve a longer time frame than originally contemplated, which may negatively impact the Fund’s returns. The Fund’s investment strategy may result in high portfolio turnover, which, in turn, may result in increased transaction costs to the Fund and lower total returns. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks. These risks may be greater for emerging markets. Diversification does not eliminate the risk of experiencing investment losses. Stock prices of mid and small capitalization companies generally are more volatile than those of larger companies and also more vulnerable than those of larger capitalization companies to adverse economic developments. The Fund is non-diversified and is susceptible to greater losses if a single portfolio investment declines than would a diversified fund. The ETF should be considered a speculative investment with a high degree of risk, does not represent a complete investment program and is not suitable for all investors. The Fund may experience a portfolio turnover rate of over 100% that will increase transaction costs and may generate short-term capital gains which are taxable.

The IQ Merger Arbitrage Index is the exclusive property of IndexIQ which has contracted with Solactive to maintain and calculate the Index. IndexIQ® and IQ® are registered service marks of IndexIQ. The IQ Merger Arbitrage Index seeks to achieve capital appreciation by investing in global companies for which there has been a public announcement of a takeover by an acquirer. HFRI ED Merger Arbitrage Index tracks the investment process primarily focused on opportunities in the equity and equity related instruments of companies which are currently engaged in a corporate transaction.

Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the entire market or a benchmark.

Correlation is a statistical measure of how two data points, such as an indexes or investment, move in relation to each other over a certain time period.

Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates.

The Federal Funds Rate refers to the interest rate that banks charge other banks for lending them money from their reserve balances on an overnight basis.

Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk.

Downside capture, or the down-market capture ratio, is a statistical measure of an investment manager’s overall performance in down-markets. It is used to evaluate how well an investment manager performed relative to an index during periods when that index has dropped.

The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market.

The MSCI World Index is a free float-adjusted market capitalization-weighted index that is designed to measure the equity market performance of developed markets.

The S&P 500® Index is widely regarded as the standard index for measuring large-cap U.S. stock market performance.

Liquid alternatives (liquid alts) are alternative investment strategies that are available through alternative investment vehicles such as mutual funds, ETFs, and closed-end funds that provide daily liquidity.

This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

Consider the Fund’s 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 Fund and are available by visiting nylinvestments.com/etfs or calling 888-474-7725. Read the prospectus carefully before investing.

New York Life Investments is a service mark and name under which New York Life Investment Management LLC does business. New York Life Investments, an indirect subsidiary of New York Life Insurance Company, located at 51 Madison Avenue, New York, New York 10010, provides investment advisory products and services. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC and serves as the advisor to the IndexIQ ETFs. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs. 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.


Dan Petersen, CAIA®

Director, Product Management, IndexIQ

Dan Petersen is a Product Manager at IndexIQ, responsible for developing actionable content as it pertains to the competitive landscape, analyzing fund usage in the latest market environment, and portfolio positioning for both individual portfolios and broader-based applications

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