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Why the federal budget deficit is returning to normal levels

Marc Wiersum, MBA

Fixed income ETFs: Short-duration alternatives for bonds (Part 3 of 5)

(Continued from Part 2)

The federal budget deficit

The below graph provides additional support for the economic recovery thesis. Since Obama raised capital gains taxes from 15% to 20% (for the top tax bracket) in the face of a government-induced economic rally, capital gains tax–related revenues have helped pay down the crisis-induced federal debt.

This article considers the ongoing decline in the federal budget deficit and considers 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.

Capital gains, deficit wanes

In 2007, at an equity market peak, long-term capital gains taxes reached 6.14% of GDP, or approximately $118 billion. In contrast, at the bottom of 2009, capital gains taxes fell to 1.62% of GDP. 2013 saw a growth in capital gains-related tax receipts as taxpayers sought to make final payments on 2012 tax receipts under the 15% rate regime. Accordingly, 2013 capital gains tax revenues reached $483 billion, or roughly 3.00% of GDP. As the stock market reaches new highs, it’s possible that the growth in capital gains–related tax revenues alone could be almost enough to put an end to the current federal budget deficit, which is now less than 4.00%.

More pressure on bonds

As the federal budget deficit shrinks and the Federal Reserve Bank buys fewer Treasury bonds as part of its “QE3” bond buying program, it would appear that the post-crisis bond buying spree could be slowing down. As we discussed earlier, the fairly rapid rise of the ten-year bond from 1.5% in July 2012 to 3.0% in December 2013 reflected investors’ concerns that the fundamental supply and demand balance for long-dated bonds was changing and will likely continue to reflect less demand in the future. Accordingly, as economic growth returns to historical averages, budget deficits shrink on tax revenue gains, and the Federal Reserve Bank buys fewer bonds, and long-dated bonds. Fixed income–related bond ETFs with longer durations may experience further price declines.

To see why the continued decline in the U.S. ten-year Treasury bond has affected fixed income ETF returns, 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 4

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