Short-term rates must-know: Why the Fed is fighting deflation

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Fixed income ETFs: Short-duration alternatives for bonds (Part 5 of 5)

(Continued from Part 4)

Fed funds

The below graph reflects the federal funds target rate, which is the interest rate that depositors, such as U.S. Banks, receive at the Federal Reserve Bank on their overnight cash deposits. This rate had reached 5.25% in June 2007, as the Federal Reserve Bank under Chairman Alan Greenspan had hoped to cool the speculative investment fervor that had swept into the U.S. economy, and which was apparently contributing to investment bubbles in housing, equities, and speculative investments in general. As noted by the subsequent collapse in the federal funds rate post-2008, the Federal Reserve Bank certainly was successful in cooling the investment climate in the USA.

This article considers the ongoing low rates in the short end of the yield curve and the implications for fixed income investors. For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.

Zero interest rate policy

The Federal Reserve Bank has essentially maintained a zero interest rate policy since the 2008 economic crisis, paying around 0.10% on deposits. The Federal Reserve Bank has kept this overnight rate low, in conjunction with other policies, to keep interest rates low, so that the economy may recover. The Bank of Japan did the same thing in 1999, though it has yet to raise the overnight rate as the result of creating a self-sustained economic recovery. Perhaps the USA will fare better in this regard.

The specter of deflation

One of the main reasons that the Federal Reserve Bank has kept the Federal Funds rate so low is to increase inflation in the USA, and to inhibit the onset of price deflation. When deflation creeps into a slowing economy, the prices of assets decrease, and it becomes harder for banks to loan money against assets that decrease in value in the future. Consequently, in a deflationary environment, banks lend less, and consumers buy less, with the expectation that everything will have a lower price in the future. Such a dynamic can be self-reinforcing and create a negative feedback loop of ever-decreasing prices.

For additional analysis related to other key fixed income ETF tickers, please see the related series Fixed income ETF must-know: Has the bear market in bonds begun?

Short duration, higher credit risk: SNLN & BKLN

If investors are concerned about a rising rate environment, they may wish to consider short-duration fixed income exposure through short-duration fixed income ETFs such as the Highland/iBoxx Senior Loan ETF (SNLN). This ETF holds senior bank loans, which offer a floating rate coupon based on short-term interest rate pricing—which is typically the 90-day interbank rate, known as “three-month LIBOR.” (LIBOR stands for the “London Interbank Offer Rate on Deposits,” and it’s established daily through a consortium of banks under the British Banker’s Association in London.)

Similarly, the Invesco PowerShares Senior Loan Portfolio ETF (BKLN) also holds senior bank loans and also has a short duration. The duration of these “floating rate” loans is typically 40 to 60 days—much shorter duration than the typical four-year duration associated with similar corporate five-year bond portfolios. The loan portfolios also carry an additional advantage over longer-duration corporate bonds in that they have a much higher average recovery of loss rate compared to corporate bonds—closer to 80% compared to closer to 50% in the case of similar rated bonds.

It’s important to note that both these ETFs invest in loans that are rated in the BBB-B area and they involve more risk of loss than portfolios rated in the AAA-A area. However, what they lack in credit rating they tend to compensate for in terms of higher returns. SNLN offers a yield-to-maturity of around 4.8%, and BKLN around 4.95%.

Longer-duration, lower-credit-risk alternatives: AGG & LQD

If you’re wary of credit risk, you could also consider longer-duration ETFs such as the iShares Core Total U.S. Bond Market ETF (AGG). It maintains a duration of 5.11 years, though it has a yield-to-maturity of 2.14%, as it holds roughly 70% of its portfolio in AAA and AA rated bonds. Similarly, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) offers a duration of 7.49 years and a 3.35 yield-to-maturity, and it holds the majority of its bonds in the A to BBB category. LDQ includes higher commercial credits such as Verizon (VZ)(0.70%) and Blackrock Funds (BLK)(0.67%), whereas SNLN holds lower-rated commercial credits such as Caesar’s Entertainment (CZR)(2.35%) and Hudson’s Bay Company (HBC)(1.50%).

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