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Recovery continues: The US government is back on budget!

Marc Wiersum, MBA

Fixed income ETFs: Short-duration alternatives for bonds (Part 1 of 5)

Government spending

The below graph reflects a very positive development for the USA—not to mention the Obama Administration. Government spending is back to normal. After hitting 24.4% of gross domestic product (or GDP) in 2009, the government has made substantial progress in reining in runaway spending as well as returning the economy to growth. Government spending has now returned to its historical average of right around 20% of GDP. If expenditures related to items such as unemployment insurance and defense remain subdued, and economic growth continues, it might be reasonable to expect even further progress in this area.

This series takes a quick look at past and present economic growth data, government spending, interest rates, and inflation and it considers the outlook for ETF-focused fixed income investors amid a rising rate environment. 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.

The end of runaway deficits?

The conservatives will likely welcome this apparent improvement in the federal budget. As the government spends less as a percentage of the economy, risks of inflation and currency devaluation are mitigated. With the budget under control, funding pressures to issue more debt can and should subside. This is positive for bond prices, as less relative bond supply due to fiscal deficits mean demand could tighten. Plus, with the Federal Reserve (the Fed) still purchasing $75 billion bonds per month via its QE3 monetary accommodation policy, there’s still significant demand for bonds in the market. As the economy (hopefully) improves, it might be reasonable to expect the private sector to step in while the Fed exits its bond buying program.

The net effect

The net effect of ongoing economic and fiscal recovery should also be felt on the monetary side of the economy as well. As the economy improves, the government debt supply should remain muted while the Fed buys fewer bonds. In all likelihood, the net effect of economic improvement should outweigh the Fed’s bond buying operations during a fiscal overspending regime. As a result, you’d expect higher interest rates to develop, as long as the recovery continues, and more normal levels of inflation of closer to 2.0% to return to the economy.

To see how economic growth is contributing to rising 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. 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%).

Continue to Part 2

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