Let’s face facts: At the moment, bonds aren’t the most popular investment out there. Only a month ago, the global bond market tanked, largely because of euro-area jitters. The global selloff did impact euro-area bonds rather substantially, but U.S. bonds and bond funds did not go unscathed.
In fact, for numerous reasons, U.S. Treasuries experienced the worst selloff in several months. But the greatest among them is the broadening consensus that the Federal Reserve is gung-ho for a rate hike this year.
When interest rates rise, bonds get hit, so investors’ automatic reflex is to ditch bonds, and ditch them fast, when things look rosy for rates.
But do you have to similarly worry about bond ETFs – even those that are being actively managed for you?
As I’ll explain, bond funds are an entirely different case.
Actively Managed Bond ETFs
The best value that an actively managed bond ETF can provide isn’t protection – protection would be nice, but it’s really a bit too much to ask.
But smart diversification? Well, that’s horse of a different color.
An active bond ETF, when well-managed, can allow you to maintain a segment of your portfolio in the fixed income space, in turn allowing you to maintain diversification and optimize returns from a wide range of actively trading bonds. And that is irrespective of type; from U.S. sovereign bonds and mortgage papers, to bonds in developed and even emerging markets.
Now that we’ve laid out the key benefit of an actively managed bond ETF, let’s look at it in real life.
Fed Says Hedge America
The news every bond investor should care about: last week’s FOMC meeting and Janet Yellen’s speech. After all, actively managed or not, any bond strategy should take into account what the Fed is thinking.
The Fed had two main points. First, that rates probably would rise this year, but only by 0.25%. Second, future rate hikes (beyond the first) also are likely to be extremely low. The Fed has supported its relatively downbeat tone by lowering its forecast for growth and for inflation in 2015 and 2016.
What does it all mean? Essentially, the U.S. might not be outperforming everyone else by as much as some believe. This effectively undermines the strength of the U.S. dollar, and it forces investors to ponder diversification into Asia and Europe (once the dust settles from the Greek saga).
Inevitably, the dollar could soften and assets elsewhere could outperform for a while — even if the U.S. economy outshines in the mid- to long term.
This presents a challenge for bond investors. After all, if the dollar depreciates while other currencies gain, you might be better off diversifying into non-dollar-denominated fixed-income assets.
Moreover, if rates do rise, even slowly, you still have to have an effective strategy upon maturity.
That’s where the Pimco Total Return ETF (BOND) comes in.
Why BOND Is Tops
The Pimco Total Return ETF is geared toward this kind of scenario – namely, uncertainty mixed with possible dollar weakness.
The BOND ETF has three major strengths that allow it to outperform under those circumstances:
- Pimco Total Return’s strategy is to purchase high-quality bonds. And by high-quality, we mean going up the ladder in the capital structure, i.e. senior debt. If there is a risk of default in an investment, Pimco’s stance as a creditor is higher up on the food chain. Because it’s deemed safer, its holdings — even if in more exotic locales such as India or South America — are better positioned.
- Then there’s global diversification. The BOND ETF is spread across the world from Mexico to Germany to Brazil and, of course, in the U.S., meaning it’s highly geographically diversified.
- BOND distributes its holdings across a wide array of maturities, which further reduces its downside risk.
But do BOND’s strengths actually translate into performance?
Halfway through 2015, and it’s clear this will be a tough year for the bond markets. Bond ETFs have sold off heavily … but you can still clearly see the benefit of active management. Year-to-date, BOND has returned 0.41% — it has declined in price, but income has made up the difference and then a little. However, even including income, the index-tracking Vanguard Total Bond Market ETF (BND) has slumped 0.56%. That’s not insignificant.
That outperformance continues in the longer term. For instance, over the past two years, BOND has returned 8.5% to BND’s 6.28% (and remember, this is during a pretty flat overall period for bonds). And since inception in February 2012, BOND has delivered a total return of 18.08% versus just 5.5% for BND — more than 12 percentage points of difference.
So what’s the catch?
Rapid dollar appreciation is the single factor that could potentially surprise BOND managers. That would leave the fund exposed, with its foreign holdings losing value in dollar terms. In exceptional circumstances, such as a black swan event looming overseas or a sudden acceleration of U.S. inflation, that could be problematic.
Still BOND’s managers likely would have time to diversify away … and once again, limit downside risk.
Simply put, the BOND ETF provides excellent, diverse exposure to a high-quality bond portfolio while presenting limited downside.
As of this writing, Lior Alkalay did not hold a position in any of the aforementioned securities.