With the release of this morning’s February jobs report, the 10-year Treasury yield has leapt nearly 15 basis points to 2.50%. The knee-jerk reaction in rates caused the iShares 7-10 Year Treasury Bond ETF (NYSEARCA:IEF) to fall roughly 1%, while the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) dropped over 2%.
This is largely in response to market participants hoping for a “goldilocks” number. I categorize that as strong enough to keep stock investors happy with economic momentum, but low enough for bond investors to shake off worries the could Fed could raise rates mid-year.
This notion was completely thrown out the window with an increase in nonfarm payrolls of 295,000 jobs, even in spite of nasty winter weather griping a large portion of the nation and the relatively short month of February. From our perspective, the February jobs report was very strong, and there is no doubt the American economy is at escape velocity.
The only question that remains is what does this mean for your fixed-income investments for the remainder of 2015?
Shorten Your Duration
For investors in our Strategic Income Portfolio, we have spent the last two months shortening duration with several key transitions. These changes have contributed to a fixed-income sleeve that exhibits duration and therefore interest rate volatility of less than half that of the Barclays Aggregate Index, or the index that the iShares Core U.S. Aggregate Bond ETF (NYSEARCA:AGG) and Vanguard Total Bond Market ETF (NYSEARCA:BND) are linked to.
In my opinion, if you haven’t taken steps to lower your duration in the first part of 2015, making changes now likely won’t yield the same effect you’re hoping for unless interest rates continue to rise at a breakneck pace.
This rising-rate scenario is unlikely due to the relative value and yield of U.S. Treasury securities on a global basis, especially viewed through the lens of a quickly rising U.S. dollar. Furthermore, rates are not likely to cross key technical levels of 2.4-2.65% without a significant catalyst.
However, I do believe investors can still make common sense changes to alter the characteristics of their fixed-income portfolio to better align with future probabilities.
The likelihood that we have experienced a long-term secular low in rates is rather high, seeing as though we would probably have to re-enter a recessionary or deflationary environment to meaningfully change the momentum in high quality bonds. Therefore investors seeking to maintain their income stream while lowering their exposure to interest rates could consider low-duration high yield securities or leveraged loans. Yet, I don’t recommend investors establish dedicated sector positions without the means to identify the circumstances in which they would alter their portfolio to adapt to changing market environments.
A great “all-in-one” alternative for many investors is to utilize is a strategically managed total return strategy such as the newly launched SPDR Doubleline Tactical Total Return ETF (NYSEARCA:TOTL). The fund, managed by bond guru Jeffrey Gundlach, will seek to lower interest rate volatility by sidestepping the large allocation to Treasury securities imbedded in the Barclays Aggregate Index, while in turn allocating to the aforementioned sectors to balance quality securities with credit exposure.
Bottom Line
Moving forward, investors will need to adopt strategies such as TOTL to balance cash flow with underlying asset volatility. Success in fixed-income management demands flexibility, and whether you’re implementing your own asset mix or relying on funds like TOTL, the remainder of 2015 can still result in attractive returns by making key changes now.
Michael Fabian is Managing Partner and Chief Investment Officer of FMD Capital Management. To get more investor insights from FMD Capital, visit their blog.
