A reader recently sent me a question asking why you would own bond funds when interest rates are on the move higher. This type of sentiment is more than likely on the minds of many investors as they prepare for 2017 and evaluate adjustments to their asset allocation.
The short answer is that every diversified portfolio should have bond exposure to balance out the risk of other asset classes (e.g., stocks and commodities). Bonds have historically provided a shock absorber for the equity side of the portfolio and have not shown any signs of relinquishing that trait. Simply letting go of all your bond exposure will unnecessarily tilt your risks and returns towards a single outcome.
It’s like driving without a seat belt on. Everything will be fine … until it’s not.
Furthermore, bonds provide a much-needed stream of income for those what rely on dividends. A rising-rate environment will depress bond prices, but it will also stimulate higher yields across virtually every sector of the bond market.
The benchmark that most investors will base their bond performance against is the Barclays U.S. Aggregate Bond Index. This is the same index that the two largest bond ETFs in the world are based on. Those being the iShares Core U.S. Aggregate Bond ETF (NYSEARCA:AGG) and Vanguard Total Bond Market ETF (NYSEARCA:BND).
These bond funds share a combined $73 billion in passively managed assets. They are also susceptible to more interest-rate risk due to high concentrations of Treasuries, investment-grade corporate bonds and mortgage-backed securities.
Fortunately, there are several core bond ETFs that have managed to successfully mitigate the risk of rising rates through security selection and duration positioning.
Cream-of-the-Crop Bond Funds: Vanguard Short-Term Bond Index Fund (BSV)
SEC Yield: 1.69%
If your goal is low cost and index-like returns, you can’t go wrong with a fund like Vanguard Short-Term Bond Index Fund (NYSEARCA:BSV).
This Vanguard ETF takes the approach of significantly shortening the duration of its holdings versus a traditional intermediate-term benchmark; BSV has an effective duration of 2.8 years versus 5.9 years in BND. (Remember: Effective duration is essentially the measure of a fund’s sensitivity to interest rate fluctuations.)
BSV charges an ultra-low expense ratio, has exposure to 2,400 underlying holdings and boasts nearly $20 billion in assets under management. The portfolio is allocated using similar sector exposure to the Barclays Aggregate index, with the majority of holdings rated as high credit quality.
The downside to BSV is going to be its meager income stream. The fund currently sports a 30-day SEC yield of just 1.69% and income is paid monthly to shareholders. Such is the trade-off of lowering price volatility at the expense of the dividend payments.
Cream-of-the-Crop Bond Funds: SPDR Doubleline Total Return Tactical ETF (TOTL)
SEC Yield: 3.01%
SPDR Doubleline Total Return Tactical ETF (NYSEARCA:TOTL) is an excellent selection for those that want an active approach to fixed-income. This fund is managed by Jeffrey Gundlach of DoubleLine Capital using a multi-sector approach to its asset allocation. It’s a fund that I currently own for myself and clients of my wealth management firm.
The advantage of an active fund like TOTL is that it has more flexibility in security selection and risk management capabilities than an index. The fund manager can increase or decrease the effective duration, as well as shift assets towards areas of the bond market they feel offer greater value. There are also limits (or guidelines) on sector exposure that make this fund suitable as a diversified core holding.
Right now, TOTL yields 3.02% and has an effective duration of 5.02 years. It also carries exposure to bank loans, emerging market debt, and other asset backed securities that you won’t find in many benchmarks.
It’s worth pointing out that TOTL charges an expense ratio of 0.55%, which is significantly higher than a passive ETF. As an active fund, it is also susceptible to underperform its benchmark if its positioning doesn’t blend well with the fixed-income environment. Nevertheless, this bond fund has weathered the recent jump in interest rates in a much smoother fashion than its peer group.
Cream-of-the-Crop Bond Funds: Pimco Total Return Exchange-Traded Fund (BOND)
SEC Yield: 2.7%
Pimco has always been a leader in fixed-income, and its flagship total return bond fund continues to perform at a strong pace.
The most interesting thing about PIMCO Total Return Exchange-Traded Fund (NYSEARCA:BOND) is its use of futures and currency swaps to manage risk. The portfolio is currently balanced between conventional U.S. fixed-income exposure paired with interest-rate hedges, inflation protected bonds and emerging-market debt.
Over the past six months, this has led to diminished price volatility versus the Barclays benchmark.
Pimco takes a team approach to its credit and security selection criteria within the BOND portfolio as well. The effective duration is currently 5.71 years with a 30-day SEC yield of 2.7%. Its objective has always been one of a core holding for investors to utilize in lieu of a diversified index. Furthermore, the fund charges the same expenses as TOTL.
For full disclosure, we currently recommend BOND for subscribers to the Flexible Growth and Income Report.
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. As of this writing, Fabian was long TOTL, and FMD Capital Management has recommendations on both BOND and TOTL. To get more investor insights from FMD Capital, visit their blog.