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Using Bond ETFs To Hedge Against Fed Hikes

High yield bond ETFs have seen a steady rally in recent months, thanks largely to changing investor sentiment toward risk. One of the funds delivering the most impressive gains, however, is one of the segment’s smallest.

Bryce Doty is senior portfolio manager at Sit Investment Associates. He manages two bond mutual funds for the firm, as well as the Sit Rising Rate ETF (RISE), which came to market early last year. ETF.com recently caught up with Doty to discuss the outlook for fixed-income markets ahead of today’s Fed decision.

ETF.com: How many times do you see the Fed hiking rates this year?

Bryce Doty: One to two times. At this week's Fed meeting, you'll see this continued tug of war between the Fed governors who think that they should raise rates sooner rather than later, offset by the dovish stance of Janet Yellen.

There's going to be this back and forth, which will continually add volatility to both the stock and bond markets.

ETF.com: Even with more Fed rate hikes presumably coming later this year, long-term Treasury yields remain low, with the 10-year bond yield below 2%. Do you see that changing at all?

Doty: No. If the Fed does nothing and you see inflation continue to creep higher, only then will you see 10- and 30-year yields rise, because they're the most worried about inflation.

On the other hand, the short end of the curve worries about Fed policy and what the current Fed funds target rate is.

If the Fed raises rates on the short end, that could actually keep yields low on the long end of the curve, thereby flattening the curve. That makes sense because it shows the market that the Fed is not asleep at the switch as it pertains to rising inflation trends.

ETF.com: A big story earlier this year was the volatility in credit spreads. They blew out in January and now they've come back in. Do you have any thoughts on that?

Doty: It was a flight to quality. You have all these indexed-bond ETFs, which have a significant component of energy. If you're in an index fund rather than a managed bond portfolio and you want to get out of the way of the energy freight train coming right at you, you have to sell the whole index.

That selling drove spreads out across the board―which is a new phenomenon that we're feeling from ETFs.

Once people were able to get away from the energy debacle, they stopped selling and readjusted their weightings and portfolios accordingly, and that allowed spreads to snap back on companies that were being thrown out with the bathwater.

You had a lot of companies whose spreads widened, even though their earnings were fine and nothing else had changed, other than this technical selling pressure from the high-yield index.

ETF.com: Based on your outlook, how do you think fixed-income investors should be positioning themselves?

Doty: It pays to protect right now. There's a lot of volatility, and that volatility is going to continue.

The Fed had been suppressing volatility by being so stimulative and printing so much money with its QE programs. All that is gone. The market has to stand on its own two feet now.

We manage $14 billion in stocks and bonds. My group is responsible for $6.5 billion of taxable bonds. Our clients are used to their bonds being the safe portion of their portfolio or the anchor of their portfolio. But in the past six months, it's been anything but that, and they're understandably not comfortable with the volatility.

So what we've been doing is implementing strategies to act as shock absorbers against all that volatility. That's where the Sit Rising Rate ETF (RISE) is a very useful tool.

RISE shorts two- and five-year Treasurys primarily because they’re the most sensitive to a change in Fed policy. With just a 10-15% allocation, you can greatly reduce interest-rate risk while maintaining the income off your bond portfolio. It's the least disruptive way to hedge your portfolio.

It's tough for me to sit there and watch people shorten duration by going into, for example, a short-duration government fund. First of all, you give up tons of yield; you probably are paying capital gains tax; and you're right in the bull's eye part of the curve that's going to get hurt if the Fed does raise rates.

I'd rather people keep something like the iShares National Muni Bond ETF (MUB | B-79) or the SPDR DoubleLine Total Return Tactical ETF (TOTL | C). Combine it with the iShares TIPS Bond ETF (TIP | A-99), the iShares Floating Rate Bond ETF (FLOT | B-98) and RISE.

Then you end up with a two-year-duration bond portfolio that still has some decent income—either tax exempt or taxable, whatever your preference is. You get a little inflation protection from TIP and a little Fed protection in RISE.

Rather than using the money market for some of your cash, use FLOT, and if short rates go up, your yield goes up with them.

I like those kinds of ideas rather than just going into short duration.

Contact Sumit Roy at sroy@etf.com.

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