Navigate rising rates using a 'barbell' ETF duration strategy

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  Morgane Delledonne 
  ETF Investment Strategist

 

 

Key takeaways

  • A maturing economic cycle, trade war threats and rising financing costs are leading to lower duration risk but rising credit risk
  • US investment grade corporate bonds should be supported by lower issuance activity and lower appetite for risk in the medium term
  • Within this environment, a ‘barbell’ strategy can provide short-term flexibility and long-term yield

Risk appetite waning

Ongoing trade disputes coupled with the potential overheating of the US economy have increased uncertainty, reducing the demand for risk assets. High yield bond ETFs have recorded net outflows since the start of the year despite better performance relative to investment grade (IG) credit. Furthermore, ultra short (less than 1 year) and short-term (less than 3 years) bond ETFs have recorded the largest net inflows across all maturities year-to-date, suggesting investors prefer lower duration strategies amid rising interest rates.

Credit risk likely to rise

However, the duration risk is likely to become less prominent in the medium term due to the US yield curve being almost flat. The 10-year US Treasury yield may have reached a cyclical peak, hovering around 2.9%, which coincides with the Federal Open Market Committee’s current estimate of the long-term target rate and has been a psychological ceiling to US yields in the past. Conversely, credit risk is likely to rise amid a maturing economic cycle, trade war threats, and rising financing costs. While high yield bonds reduce interest rate sensitivity and increase yield, they are more correlated to equities (around 60%). Investment grade corporate bonds are likely to be less vulnerable to tighter financial conditions while also being less correlated to equities (around 30%), providing protection against an equity bear market.

Typically, corporates start deleveraging their balance sheets at this stage of the cycle, which should constrain new bond issuance in the medium term. Against this, the global demand for US assets is likely to remain strong due to the interest rates differentials with other major economies, despite the higher cost of hedging for non-US investors. Overall, US IG corporate bonds, which account for almost half of the Bloomberg Barclays Global Aggregate Corporate Index, should be supported by the gradual portfolio rebalancing towards lower risk assets in the medium term.

Implementing more sophisticated solutions - a barbell strategy

While interest rates are rising, they remain low from a historical perspective. Therefore, holding only short-dated bonds may not deliver income requirements. An alternative option is implementing a barbell strategy. This involves investing in short-term bonds with minimal duration risk thus enhancing capital preservation, and also investing in long-term bonds for higher income. This strategy performs well when the yield curve is flattening.

Challenges for the investor

Managing a barbell strategy can be challenging because investors must roll over their short-term bonds as they mature, into a new series. However, building a barbell strategy using ETFs removes this complexity due to the short-term bonds being rolled over automatically in the ETF.

Barbell strategy using ETFs – a worked example

We have constructed an illustrative barbell portfolio (“BMO Barbell ETF Portfolio”), which is divided into two buckets, the BMO Barclays 1-3 year Global Corporate Bond UCITS ETF (ZC1G) and the BMO Barclays 7-10 year Global Corporate Bond UCITS ETF (ZC7G). The short maturity bucket is comprised of IG bonds with at least one year to maturity but less than three years to maturity, and the long maturity bucket comprises bonds with at least seven years to maturity but less than 10 years. The BMO Barbell ETF Portfolio holds 54.8% of ZC1G and 45.2% of ZC7G and has the same duration as the Bloomberg Barclays Aggregate 1-10 year Corporate Index (4.3 years). The chart below displays the characteristics of our example portfolio versus the benchmark.

Enhanced liquidity and capital preservation

The BMO Barbell ETF Portfolio exhibits the same average duration as the benchmark, albeit with a different maturity profile. The barbell strategy provides a greater exposure to short-dated bonds, which enhances both the liquidity and the capital preservation characteristic of the portfolio. The defensive short end is complemented by a greater exposure to longer bonds relative to the benchmark, which increase the overall yield of the BMO Barbell ETF Portfolio above that of the benchmark (3.0 % vs 2.8% as of June 2018).

The geographical and sectoral exposures of the BMO portfolio and the benchmark are similar, but the BMO Barbell ETF Portfolio holds relatively higher quality bonds and therefore has a slightly lower weighted average coupon (2.8% vs 3.1%).

A peaking economic cycle calls for higher quality

The barbell strategy has performed broadly in line with the Bloomberg Barclays Aggregate 1-10 year Corporate Index over the past five years. Since the end of 2016, the slight underperformance of the barbell portfolio relative to the benchmark relates to the stronger performance of middle-rated IG corporate bonds (BBB+ to BBB-) compared to the upper range of IG corporate bonds (AAA to A-), the latter having a more prominent position in the BMO Barbell ETF portfolio. The popularity of middle-rated IG corporate bonds has been rising amid investors’ search for yield, and economic expansion. However, as the economic cycle matures and credit risk rises, investors may progressively rebalance towards the top of the credit spectrum. Higher quality corporates are likely to outperform if market conditions worsen.

Past performance does not reflect future performances. Both portfolios are GBP hedged. The analysis uses the theoretical benchmark returns using the underlying indices, namely the Bloomberg Barclays 1-3 year Global Corporate Very Liquid Index (VLI) and the Bloomberg Barclays 7-10 year Global Corporate Very Liquid Index (VLI), in lieu of the BMO ETFs. The BMO Barclays 1-3 year Global Corporate Bond UCITS ETF (ZC1G) and the BMO Barclays 7-10 year Global Corporate Bond UCITS ETF (ZC7G) have been launched in November 2015. Due to the sampling implemented in the ETF, realised return from an investment may be different. The use of ETFs incurs transaction costs and tracking differences.

The duration strategies depend on investors’ interest rate outlook, and holding different maturity buckets provides greater flexibility to adjust duration when their outlooks change.

Barbell strategies need not be equally weighted

For instance, a pension fund manager with long-term liabilities might prefer matching the duration of the bond portfolios to the time horizon of his investment, let’s say over six years. Furthermore, investors may seek to extend duration because they believe inflation will remain subdued and economic growth will moderate (i.e. lower interest rate risk), which may benefit longer duration bonds. The portfolio manager in this case could extend the portfolio’s average duration by adjusting the ETF holdings to concur with the forecast. A barbell strategy is not necessary equally weighted at both its ends, as per the example below.

  Benchmark BMO Barbell ETF Portfolio (15/85)
Fund Bloomberg Barclays ZC1G ZC7G Weighted
Weight Aggregate Corporate Index  15.0% 85.0% 100%
Number of Securities 11207 372 335 707
Weighted Avg Term Maturity 8.9 2.1 8.3 7.4
Weighted Avg Coupon (%) 3.5 2.3 3.3 3.2
Weighted Avg Current Yield (%) 3.1 2.4 3.6 3.4
Weighted Avg Duration 6.4 2.0 7.1 6.4

 

Past performance does not reflect future performances. Both portfolios are GBP hedged. The analysis uses the theoretical benchmark returns using the underlying indices, namely the Bloomberg Barclays 1-3 year Global Corporate Very Liquid Index (VLI) and the Bloomberg Barclays 7-10 year Global Corporate Very Liquid Index (VLI), in lieu of the BMO ETFs. The BMO Barclays 1-3 year Global Corporate Bond UCITS ETF (ZC1G) and the BMO Barclays 7-10 year Global Corporate Bond UCITS ETF (ZC7G) have been launched in November 2015. Due to the sampling implemented in the ETF, realised return from an investment may be different. The use of ETFs incurs transaction costs and tracking differences.

A flatter yield curve rings time for a barbell strategy

This barbell strategy has outperformed the Bloomberg Barclays Aggregate Corporate Index over the past eight years. Most of this outperformance relates to the flattening of the US Treasury yield curve, which began when the Federal Reserve decided to taper its bond-buying programme in December 2013.