Income investors face a brave new world in 2014 that is punctuated by real interest rates trending higher and the Federal Reserve slowly reducing the pace of their quantitative easing measures. This has led to fears of a massive shift in asset allocation from traditional fixed income to equities and alternative investments. In fact, many have abandoned bonds and bond ETFs altogether and have sworn off owning them for the foreseeable future.
On the flip side, stalwart income seekers have shifted a tremendous amount of their holdings to short duration or credit sensitive holdings which have thrived in 2013.
The key to success in 2014 will be to strike a balance between credit, duration and sector exposure to achieve positive returns in fixed income. One thing that can’t be discounted is the level of income, diversification and low volatility that is needed by retirees, pensions and a host of other conservative investors. Bonds shouldn’t be ignored, but rather implemented in a strategic manner while knowing there might be some speed bumps along the way.
Most investors perceive rising interest rates to be the biggest risk to bond holders over the next year. There are a couple ways that ETF investors can combat rising rates:
Rising Rate Funds
One such method would be to purchase a rising rate fund such as the ProShares UltraShort 20+ Year Treasury ETF (TBF). This short bond ETF essentially moves in the same direction as long-term interest rates and can hedge off a portion of the volatility in your fixed-income portfolio.
At this stage, it’s important to remember that interest rates have already risen considerably since their 2013 low. They will more than likely continue to meander through 2014 with a variety of ups and downs along the way. If you are planning on shorting Treasury bonds, make sure that you do so with a risk management approach that takes into account the potential for deflation.
Get a Shorter-Duration Bond ETF
Another method of insulation would be to shorten your average portfolio duration. An example of which would be to move from the iShares Core Total U.S. Bond Market ETF (AGG) to the Vanguard Short-Term Bond ETF (BSV). This would lower the effective maturity dates of the bonds in your portfolio, but also quite drastically reduce your monthly income stream. If you are dependent on the dividends from your investments, this strategy might eat into your capital over time.
Both of these strategies have been effective combatants for rising rates in 2013 as billions of dollars have shifted in this general direction. However, there are a host of perils other than rising rates that might become a reality if certain conditions are met.