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Short-term money: Why the pedal is still to the metal

Marc Wiersum, MBA

Fixed income ETF must-know: Has the bear market in bonds begun? (Part 5 of 5)

(Continued from Part 4)

Fed funds rate

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 low Federal Funds interest rate 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. This dynamic can be self-reinforcing and can create a negative feedback loop of ever-decreasing prices.

Good for short-dated bonds

Low rates are good for short-dated bonds. But with short-term rates at such low levels, there’s little room for upside to investors who hold short-term bonds—unless they expect short-term bond rates to become negative, which isn’t that likely at the moment. These short-term rates have also led to lower longer-term rates. But as we noted earlier, as economic activity in the USA has picked up, the longer-dated bonds have seen their yields double from 1.5% in July 2012 to 3.0% in December 2013. As a result, investors with longer-dated bonds in their portfolios or holders of longer-duration ETFs, such as TLT, can’t rely solely on an ultra-low short-term rate to protect their long-term fixed income investments. It’s likely that the short-end Federal Funds target rate will lift well after the longer end of the bond curve has sold off into a higher rate environment.

For additional analysis related to other key fixed income ETF tickers, please see the related series Fixed income ETFs: Short-duration alternatives for bonds.

Outlook: High credit quality and longer-duration (TLT & BND) versus lower credit quality and mid-duration (HYG & JNK)

For fixed income investors concerned with rising interest rates and falling bond prices, long-dated (long duration) ETFs such as the iShares 20+Year Treasury Bond ETF (TLT) may continue to see price declines if interest rates continue to rise. Note that the TLT ETF has a duration of approximately 16.35 years—roughly twice that of the current ten-year Treasury bond at 8.68 years. In contrast to the long-dated TLT, the iShares iBoxx High Yield Corporate Bond ETF, HYG, has a much shorter duration of only 3.98 years, as well as exposure to improving commercial credit markets, and may continue to outperform the long duration TLT ETF in a rising rate environment.

However, investors should note that the High Yield portfolio of HYG holds roughly 90% of its portfolio in bonds rated BBB3 through B3, with roughly 10% of its portfolio in CCC-rated credit (substantial risks). HYG top holding includes Sprint Corp (S) at 0.56% of the portfolio. The Vanguard Total Bond Market ETF (BND) maintains a duration of 5.5 years, though it holds 65.4% of its portfolio in government bonds and 21% of his holdings in AAA–A rated bonds. Compared to HYG and JNK, the BND ETF is slightly longer in duration (BND 5.5 years versus HYG 3.98 and JNK 4.20). But it’s very much concentrated in government and high-quality bonds, and will therefore be less impacted by changes in the overall commercial credit markets.

Lastly, for investors looking to maintain yield while gaining exposure to the commercial credit market, an alternative to the iShares HYG, the Barclays High Yield Bond Fund ETF (JNK), offers a similar duration of 4.20 years versus HYG’s 3.98 years, holding 84.17% of its portfolio in corporate industrial, 7.65% in corporate utility, and 7.5% in corporate finance-oriented bonds. Like HYG, even JNK is a big fan of Sprint (S), with its top holding of First Data Corporation (0.72%) followed by Sprint Corp. (0.62%), Sprint Communications (0.59%), and HCA Inc. (0.53%).

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