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.
With the shortening of duration, many investors have taken on more credit risk than historical norms. This has created what many describe as a bubble in high-yield debt that has the potential to unwind if we start to see an economic slowdown or rush for the exits. A stumble in the stock market could trip up junk bonds and send money fleeing from equities and credit sensitive holdings.
Right now we are still in an uptrend with respect to high yield, bank loans and convertible bonds, which is why I am recommending you hold onto your exposure in these areas. However, I am closely monitoring these high-yield sectors for signs of a reversal, which would warrant moving a portion of capital back to more quality bond ETFs such as the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) or the iShares MBS ETF (MBB).
These bond ETFs, along with Treasuries, would likely do well in a deflationary environment under the scenarios of a flight to quality.
Another correlation I am monitoring with respect to high yield is the divergence between U.S. high-yield corporate debt and emerging market bonds of a similar credit quality. Consider that the iShares High Yield Corporate Bond ETF (HYG) is trading near all-time highs and has a comparable yield to the WisdomTree Emerging Market Corporate Bond ETF (EMCB). However, EMCB is still more than 5% off its high-water mark.
I expect this divergence will eventually correct, and we could see money flow into emerging markets as fixed-income investors find more value and diversification overseas next year.
Picking the right fixed-income ETF or mutual fund that suits your needs is all about evaluating your risk tolerance and investment objectives. You should do some analysis of top performing funds from previous years and ask yourself how they will perform under certain scenarios.
If the Fed decides to speed up or slow down it’s taper agenda, you might have to shift your portfolio to cope with changing dynamics. In addition, it’s important to keep an eye on the health of equity- and credit-sensitive markets as these will impact the bond market in the coming year ahead.
One actively managed mutual fund that is one of my favorite core holdings is the Pimco Income Fund (PONDX), which takes a multisector approach to specific areas of the bond market that the manager feels will outperform. Pimco has done a fantastic job of managing interest-rate risk in 2013 and taking advantage of opportunities (both inside and outside the U.S.) when they are available. PONDX currently has an effective duration of less than five years, and a current 30-day SEC yield of 3.8%.
In a following series of articles, I will detail my thoughts on equities and alternative investments for income investors in 2014. As you evaluate your portfolio in the new year, stay balanced and agile with respect to opportunities and risks that may present themselves. That way you are prepared with a game plan to shift your asset allocation when needed and overcome any obstacles that you may encounter.
Here’s to a healthy and wealthy new year!
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. To get more investor insights from FMD Capital, visit their blog.