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Fixed Income Investors Should Keep Duration on a Short Leash

This article was originally published on ETFTrends.com.

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.

External Headwinds for Fixed Income

A combination of rising interest rates, a healthy injection of government debt into the markets and other external factors has made for a more intricate bond market. If the sell-offs in October portend that the decade-long bull run may be exiting out of its late market cycle, then the environment for fixed-income investors will only get more complex.

"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."

Related: Manage Inflation Expectations With ‘RINF’ ETF

Short Duration Options

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--such as short duration bond exchange-traded funds (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.

SPSB invests at least 80 percent of its total assets in securities designed to measure the performance of the short-termed U.S. corporate bond market. Ideally, shorter-term bond issues with maturities of three to four years are ideal to minimize duration exposure should the bull market enter another correction phase.

"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."

Investment Grade Short Duration Option

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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