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Why the Fed’s $4 trillion war on deflation affects ETF investors

Marc Wiersum, MBA

Key strategy: Will deflation contain the bear market in bonds? (Part 3 of 6)

(Continued from Part 2)

A war on deflation

The below graph reflects the Federal Reserve Bank’s “war on deflation.” Since the economic crisis of 2008, the Fed has increased its purchase of bonds (“assets”) in an attempt to provide liquidity (“cash money”) into the U.S. banking and financial system. Much ado has been made in the political world about this somewhat interventionist role played by the U.S. central bank. With a $15.6 trillion gross domestic product, it would appear that the Fed has injected roughly 25% worth of the U.S. GDP in cash liquidity into the U.S. financial system since the 2008 crisis, and the Fed shows signs of continuing to grow assets or bond purchases. Despite the decline in purchase rates from $85 billion per month to $75 billion, the Fed may still continue to add roughly $900 billion in assets (bonds) to its balance sheet over 2014.

This article considers growth in Federal Reserve assets and the implication 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.

Fight the Fed?

As a general rule, it’s not a good idea to take a position contrary to the explicit goals of a central bank. While a few lucky investors have done so, such as George Soros when he made his first $1 billion dollar gain in shorting the British pound in 1992, most contrarians don’t fare so well. Central banks around the world are continuing to pump cash liquidity into the global financial system. As above, the USA has done so to the tune of 25% of GDP. The Japan Central Bank has done so to the tune of nearly 50% of GDP so far, or $2.7 trillion.

To see how global central banks’ purchases of $9 trillion in assets is impacting bond yields, please see the next article in this series.

For additional analysis related to other key fixed income ETF tickers, please see the related series A flagging consumer price index contains the bear market in 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 JNK, HYG is also a big fan of Sprint Corp. (S)(0.62%) and First Data Corp. (0.44%), and it also holds CIT Group (CIT)(0.26%), Caesars Entertainment (CZR)(0.24%), T-Mobile USA (TMUS)(0.24%), Tenet Healthcare (THC)(0.24%), Ally Financial (ALLY)(0.23%), and SLM Corporation (SLM)(0.22%).

Continue to Part 4

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