How to play fixed income with rising rates on the way

Taper is one thing, rising rates another but strategist offers insight into navigating the seas

Dec 26, 2013 @ 1:56 pm

By Jeff Benjamin

The bond market might have been prepared for the Federal Reserve's tapering announcement last week, but that doesn't mean financial advisers and bond investors shouldn't still be mindful of how the well-telegraphed move will affect fixed-income strategies.

The yield on the 10-year Treasury bond, which is now hovering around 3%, might not shoot through the roof as the Fed starts reducing its monthly bond purchases by $10 billion, starting in January, but it is a safe bet that yields will inch higher.

“We definitely think interest rates can move higher from here, both from a fundamental and technical perspective,” said Todd Rosenbluth, director of mutual fund research at S&P Capital IQ.

He added that since bond yield rallied following the Fed's earlier indicators that tapering would likely begin this year, he wasn't surprised to see bonds remain relatively calm following the taper announcement. But Mr. Rosenbluth does expect the yield of the closely watched 10-year Treasury to reach the 3.5% at some point in the year ahead.

“Looking well into 2014, if yields finally break out of their long-term descending channel, we think that from a technical standpoint, the 30-plus year bull market in Treasuries would be over,” he said.

For bond investors across the yield curve, the math becomes pretty straightforward.

A bond with a three-year duration, for example, should decline by 1.5% in value as the result of a 50-basis-point increase in rates.

With that in mind, Mr. Rosenbluth is advising a bit of caution along with the reminder: “Bonds are for safety.”

While the long-term trend is toward higher rates going forward — something advisers will need to constantly manage — one near-term strategy as tapering begins would be to focus on inexpensive and short-duration exchange-traded funds for some basic bond exposure.

Of the two risks associated with bond investing — credit and interest rates — rates should be the most immediate concern, which is why Mr. Rosenbluth suggests taking credit risk virtually off the table with something along the lines of the iShares 1-3 Year Credit Bond ETF (CSJ).

“We've already seen a move by investors toward the shorter end of the yield curve, and we think investors are right to be conscious of the duration risk,” he said. “And we also think there are some good opportunities across various styles."

In addition to the iShares fund, Mr. Rosenbluth highlighted the SPDR Barclays Capital Short Term Corporate Bond ETF (SCPB) and the Vanguard Short-Term Bond ETF (BSV) as examples of funds that could help add a defensive posture to a portfolio.

“For investors who want to remain diversified and have some fixed-income exposure, these ETFs represent some good ways to stay in the bond market at a low cost, where you can get paid something without taking on too much risk,” he said.

Those three ETFs carry expense ratios of between 6 and 20 basis points.

“All the yields on those three ETFs are below 1%, which means the appeal is that they are less risky,” he said. “So if rates move higher, they will either stay flat or go down less than other bond products.”

For those investors not quite satisfied with a 1% return, Mr. Rosenbluth suggests a nod toward the SPDR BarCap ST High Yield Bond ETF (SJNK).

With a 3.9% yield and a 40-basis-point expense ratio, “this introduces a whole different risk in the form of credit risk, although the duration is still around three years, so that risk is about the same as the other short-duration ETFs,” he said.

“If the economy stayed strong, but corporate earnings slowed down, this kind of fund would get hurt,” Mr. Rosenbluth added. “But we think that scenario is unlikely.”

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