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We all know the drill: the Fed raises interest rates, and the bond market falls. That’s an important equation to consider now that the decade-long era of historically low interest rates is slowly but surely coming to an end. But while bonds and the fixed income market may not be able to compete with US equities these days from a return perspective, they can still play an important role in portfolios, helping to dampen volatility and providing a much-needed income component to the more than 10,000 Baby Boomers who are retiring every day and depend on that income to fund their “golden years.”
None of that, however, changes the fact that today’s environment can be pretty challenging for anyone in the fixed income space. The 10-year Treasury is yielding less than 2.2%¹. The Fed seems determined to shrink its balance sheet and continue to hike interest rates. And the equities market is slowing after a long bull run, which has many retirees starting to worry that a bear market is waiting just around the corner.
That may all sound like bad news, but here’s the flip side of the coin: First, though it may be somewhat counterintuitive, this environment actually increases the potential to add value in the fixed income space. With yields so low to begin with, the impact of even a relatively small amount of growth can make bonds more attractive than in a more “normal” market environment. Second (and this is great news), there is finally a way to put fixed income to work in your portfolios—without feeling the brunt of rising interest rates. How? By using a new breed of fixed income ETFs.
Smart Beta fixed income ETFs are relatively new players within the ETF landscape. While there are just over two-dozen fixed income Smart Beta ETFs on the market today totaling about $4B in assets, that’s a tiny fraction of the broader ETF market which, according to a recent PwC study, is projected to jump from $3 trillion to $8.2 trillion by 2021. But while they may be small in number, Smart Beta fixed income ETFs present an important opportunity in today’s market environment—especially those that are reinventing the way fixed income can deliver value within a diversified portfolio.
If you’re already familiar with traditional fixed income ETFs, you know that in the past, most (if not all) have been market-value-weighted. For more than a decade, advisors have relied on these legacy ETFs to provide easier, cheaper, more liquid access to bonds. The problem is that they have certain structural flaws that may limit their ability to perform in certain environments. The good news is that recent product innovation has delivered a new breed of fixed income ETF that is designed specifically to retain the traditional benefits of ETFs—specifically liquidity and low cost—and potentially deliver a much better fixed income experience by improving the risk/return tradeoff.
How? Rather than trying to reinvent the wheel, these tried-and-true techniques can be used to drive bond selection and reweight the sectors in the fixed income markets. Using market data to select assets from a lower risk pool or basing the allocations on momentum can be powerful tools. Of course, the equities market is vastly different from the fixed income market. For example, because, unlike equities, bonds aren’t traded every day, standard deviation of return is replaced by other methods that use real time market data to separate bonds into higher and lower volatility camps. When determining persistence and relative strength of ongoing market trends, we can look to the sector level as opposed to the individual bonds to allow for more efficient implementation. But regardless of the method used to determine the momentum or the factors that are used to select the lowest volatility assets, each approach can add significant value by helping to create more risk efficient portfolios.
In the equities space, factor investing has proven its worth not just over years, but over decades². Time and time again, they’ve delivered. That’s true in general, as well as in certain stress environments when a market-value-weighted approach might deliver a palpable blow to a portfolio. If suitable, now may be the time to put fixed income to work in your portfolios—without feeling the brunt of rising interest rates and, even better, without reinventing the wheel.
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1. Bloomberg as of 4/17/17.2. MSCI, Research Insight “Foundations of Factor Investing,’” 2013.
IndexIQ® is the 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. Sal Bruno is a registered representative of NYLIFE Distributors LLC.