Why the recovery’s growth may lead to higher rates

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Fixed income ETFs: Short-duration alternatives for bonds (Part 2 of 5)

(Continued from Part 1)

GDP growth

The below graph reflects the severity of the 2008 financial crisis, as well as the extent of economic recovery. Despite aggressive monetary and fiscal policy measures since 2008, the recovery has been somewhat wobbly and out of step with the historical pattern of sharp recovery following sharp recession. It’s generally understood that the key structural issue underpinning this less-than-exuberant economic recovery has been a lack of fixed investment in the U.S. economy. We consider this issue in detail in the prior series U.S. investment: Have capitalists gone on strike?

This article considers the ongoing improvement in economic growth 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.

Back to trend?

The above graph reflects that, much like Humpty-Dumpty, all the king’s horses and all the king’s men haven’t been quite able to put the economic Humpty-Dumpty back together again. With enough fiscal glue and monetary grey tape, it might appear that U.S. economy is “fixed.” After all, post-2010, the economy is growing at a real rate near its long-term average, of around 2.5%, which would be considered an acceptable and sustainable level of growth by the Fed and the White House.

However, this level of growth, while respectable, has come at a fairly significant price, involving the net public-held debt of the USA nearly doubling from 35% to near 70% of GDP. Therein lies the rub. As we noted in a prior series, much ado has been made about whether or not this particular level of debt actually has any real long-term economic significance, which could contribute to declining future growth rates.

Economic growth offsets debt growth: Garden-variety Keynesianism

As we pointed out in an earlier series, it’s entirely possible that the media hype surrounding U.S. debt had grown out of proportion in relation to the actual size of the debt problem. With recent GDP growth numbers above 3.0%, it would appear to the Obama Administration that the U.S. can grow itself out of this debt and has already begun to do so.

The big question for investors as well as the White House is, “Are the current growth rates sustainable without a return to large-scale fiscal stimulus?” If current growth rates are in fact sustained in the coming months, it’s likely that the longer-dated bonds and long-duration ETFs, such as TLT, may resume their post-2012 downward trend, which seems to have been initiated by the Federal Reserve tapering announcement.

To see how an improvement in the U.S. federal budget deficit is affecting interest rates, please see the next article in this series.

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. Like LQD, AGG also holds high-quality commercial credits, such as Verizon (VZ)(0.09%) and GE Corporation (GE)(0.08%). Like SNLN, BKLN also holds lower-rated commercial credits, such as Fortescue Metals Group (FMG)(1.96%) and Valeant Pharmaceuticals (VRX)(1.48%). Note that the individual holdings of BKLN and SNLN are much larger than the holdings of the higher-credit-quality holdings of LQG and AGG, reflecting the greater diversification and the lower level of default-related losses associated with AGG and LQD.

Continue to Part 3

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