This article was originally published on ETFTrends.com.
During a volatile October month, traders headed for the entrance to bond exchange-traded funds (ETFs) just as often as they headed for the exits.
In particular, trader volume soared the most in the iShares Core US Aggregate Bond ETF (AGG), which saw $2.6 billion in withdrawals or 5% assets under management. Next, the iBoxx $ Invmt Grade Corp Bd ETF (LQD) experienced an outflux of 6% of its assets under management.
While traders headed for the exit signs in those ETFs, certain funds like the Vanguard Total Bond Market ETF (BND) saw traders come in through the front door with inflows--a sign that when volatility is roiling the stock market, investors are seeking refuge in bond ETFs.
“Record trading volumes during October’s bout of market volatility shows how fixed income investors are increasingly utilizing bond ETFs to manage risk. The volumes also show that bond ETFs have been a positive force for stability, adding liquidity and price transparency in high velocity markets,” according to a BlackRock note.
Short and Simple in a Complex Bond Market
The month of October wasn’t only a signal to stock investors that due diligence is necessary when screening for quality U.S. equities that can be resilient during times of volatility, but it also put fixed-income investors on notice that the same strategy is necessary for the bond market. One emerging theme that rose out of the volatile October was a need for more short duration exposure as external headwinds face fixed-income markets going forward.
A combination of rising interest rates, a healthy injection of government debt into the markets and other external factors has made for a more complex bond market. If the sell-offs in October portend that the decade-long bull run is over, then the environment for fixed-income investors will only get more perplexing.
“New cross-currents created by historic injections of central bank liquidity – as well as by demographics, technology, and regulation – have made it more complex,” an article in Institutional Investor noted. “A transition is under way as monetary policy normalizes, liquidity ebbs, and bouts of volatility are roiling the market. The implications for fixed income investors are significant.”
October saw Treasury yields climbing in addition to rising interest rates, causing investors to flock to shorter-duration debt issues as opposed to those with longer maturities–this forces fixed-income investors to be more diligent in their debt investments by looking into other areas of the bond market as opposed to broad exposure like short duration bond ETFs.
“We expect rising rates to cause tighter liquidity and increase dispersion, which will create opportunities to generate alpha,” said James Keenan, Chief Investment Officer and Global Co-Head of Credit. “We recommend positioning for this shift by moving up in quality and reducing duration. This will help to mitigate against unintended, idiosyncratic risks, and interest rate uncertainty.”
With the short-term rate adjustments being instituted by the Fed, investors can limit exposure to long-term debt issues and focus on maturity profiles. An example would be the SPDR Portfolio Short Term Corp Bd ETF (SPSB) , which seeks to provide investment results that correspond to the performance of the Bloomberg Barclays U.S. 1-3 Year Corporate Bond Index.
“To mitigate the impact of rising short-term rates, investors can consider targeting specific duration profiles,” Matthew Bartolini, Head of SPDR Americas Research, told ETF Trends. “In the past year, targeting the 1-3 year corporate maturity band vs. the 1-5 year band would have delivered 60 basis points of outperformance. Yields are comparable (3.31% vs. 3.41%), but the 1-3 year space has almost one year less of duration.”
Short Duration, Investment-Grade Bond ETFs
Another short-term bond ETF option is the iShares 1-3 Year Credit Bond ETF (CSJ) , which tracks the investment results of the Bloomberg Barclays U.S. 1-3 Year Credit Bond Index where 90 percent of its assets will be allocated towards a mix of investment-grade corporate debt and sovereign, supranational, local authority, and non-U.S. agency bonds that are U.S. dollar-denominated and have a remaining maturity of greater than one year and less than or equal to three years–this shorter duration is beneficial during recessionary environments or deeper corrections in the market.
With more rate hikes expected to come in the Fed’s current monetary policy agenda, Bartolini identifies the pressure on bond portfolios this has been effectuating irrespective of whether they are long or short duration. In addition, fiscal policy has also been a major factor in bond performance.
“Longer or intermediate bond funds have been affected by the Fed’s monetary policy actions. However, fiscal policy has also had an impact,” said Bartolini. “The 10-year spiked at the beginning of the year once the tax cuts were passed and debt issuance by the US government increased to fund the cuts, expanding the already high budget deficit. These actions have had an impact on inflation and longer term rates, sending them higher and bonds lower, leading to losses on particularly bond funds sensitive to those key rate durations.”
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