The start of the fourth quarter has renewed worries over the Fed rate hike on a slew of positive economic indicators. Richmond Federal Reserve President, Jeffrey Lacker, early this week cited a strong case for a rate hike in December. Additionally, the probability of a Fed lift-off in December has increased to above 60% as per the federal-funds’ futures market while CME Group's FedWatch Tool shows a 63% chance of an increase in December.
As a result, Treasury yields increased sharply with the 10-year yields now at 1.72% — the highest level in two weeks. This is especially true as manufacturing activity rebounded strongly in September with the ISM index rising to 51.5 from 49.4 in August. Additionally, the U.S. economy supposedly gained momentum in Q2 with GDP growth revised to 1.4%, up from 1.1% from the previous estimate and 0.8% recorded in Q1.
Consumer confidence spiked to the highest level since recession in September, as measured by the Conference Board, while it climbed for the first time in four months as per the Thomson Reuters/University of Michigan index. Fresh worries that ECB will gradually cut its €80 billion bond buying program ahead of the planned conclusion in March 2017 and risk-on trade have also contributed to the increase in yield.
Given the improving fundamentals, an increase in rates seems justified. As rates rise, bond investors might experience heavy losses given that bond prices and yields have an inverse relationship. While this is true, there are still several compelling choices in the fixed income ETF world that could protect investors from rising rates (read: 4 Inverse Bond ETFs to Watch as Rates Rise).
Below we highlight six bond ETFs that could be great picks in the rising rate environment.
iShares Floating Rate Bond ETF (FLOT - ETF report)
Floating rate notes are investment grade bonds that do not pay a fixed rate to investors but have variable coupon rates that are often tied to an underlying index (such as LIBOR) plus a variable spread depending on the credit risk of issuers. Since the coupons of these bonds are adjusted periodically, they are less sensitive to an increase in rates compared to traditional bonds. As such, unlike fixed coupon bonds, these will not lose value when the rates go up. Hence, it protects investors from capital erosion in a rising rate environment.
The most popular fund in this space is FLOT, which follows the Barclays US Floating Rate Note < 5 Years Index. Holding 4448 securities, the fund has an average maturity of 1.82 years and effective duration of 0.12 years. In terms of credit quality, the ETF can be considered a relatively safe option for investors as the fund focuses on better quality notes with 87% of them rated A or higher. The product has amassed over $3.2 billion in its asset base while trades in volume of 504,000 shares per day on average. Expense ratio came in at 0.20%. The fund has a dividend yield of 0.61% (read: ETF Strategies for a Rising Rate Environment).
PowerShares Senior Loan ETF (BKLN - ETF report)
The senior loans are floating rate instruments and thus pay a spread over the benchmark rate like LIBOR, which help in eliminating interest rate risk. This is because when interest rate rises, coupons on senior loans increase while the value of the bonds decline, keeping investments stable. Since these loans are issued by companies with below investment grade credit ratings, they usually pay yields in order to compensate for this risk. Given this, senior loans and the related ETFs offer higher yields along with protection against any interest rate rise, making them ideal investments. Further, they carry lower credit risk than most other assets, with a similar level of yield and have low correlations with other asset class.
The most popular and liquid fund in this space is BKLN with AUM of $5.8 billion and average daily volume of about 2.9 million shares. The fund tracks the S&P/LSTA U.S. Leveraged Loan 100 Index and holds 108 securities in its basket. It has average maturity of 4.56 years and days to reset of over 45. The product charges 65 bps in fees a year and has an attractive dividend yield of 4.61%.
iShares Short Treasury Bond ETF (SHV - ETF report)
Higher rates might lead to huge losses for investors who do not hold bonds until maturity. As a result, short-duration bond ETFs like SHV vulnerable act as a better hedge to rising rates. The fund is an actively managed and seeks to manage interest rate risk while maximizing current income through diversified exposure to short-term bonds. It holds 301 securities in its basket, with average maturity and effective duration of 0.47 years each. The product has accumulated $3.6 billion in its asset base while trades in a solid volume of more than 744,000 shares a day. It charges 15 bps in annual fees and has a yield of 0.16% (see: all the total Bond Market ETFs here).
WisdomTree Barclays U.S. Aggregate Bond Negative Duration Fund (AGND - ETF report)
Negative duration bond ETFs offer exposure to traditional bonds while at the same time short Treasury bonds using derivatives such as interest-rate swaps, interest-rate options and Treasury futures. The short position will diminish the fund’s actual long duration, resulting in a negative duration. As a result, these bonds could act as a powerful hedge and a money enhancer in a rising rate environment. Currently, there are a couple of negative duration bond ETFs, out of which AGND has AUM of $12.7 million and average daily volume of nearly 3,000 shares.
This ETF tracks the Bloomberg Barclays Rate Hedged U.S. Aggregate Bond Index, Negative Five Duration. The benchmark provides long positions in the Barclays US Aggregate Bond Index, which consists of Treasuries, government bonds, corporate bonds, mortgage-backed pass-through securities, commercial MBS & ABS, and short positions in U.S. Treasuries corresponding to a duration exceeding the long portfolio, with duration of approximately negative five years. Expense ratio came in at 28 bps.
WisdomTree Barclays U.S. Aggregate Bond Zero Duration Fund (AGZD - ETF report)
Like AGND, this fund also combats rising interest rates an utilizes an institutional style approach that combines a long position in bonds representative of the Bloomberg Barclays Aggregate Bond Index with a short position in Treasury securities to target zero duration. It follows the Bloomberg Barclays Rate Hedged U.S. Aggregate Bond Index, Zero Duration. The fund has been able to manage $23.8 million in AUM and trades in light average volume of almost 2,000 shares per day. Expense ratio came in at 0.23% (read: Prepare for Rising Rates with These Inverse & Hedged Bond ETFs).
iPath US Treasury Steepener ETN (STPP - ETF report)
This product directly capitalizes on rising interest rates and performs better when the yield curve is rising. The ETN looks to follow the Barclays US Treasury 2Y/10Y Yield Curve Index, which delivers returns from the steepening of the yield curve through a notional rolling investment in U.S. Treasury note futures contracts.
The fund takes a weighted long position in 2-year Treasury futures contracts and a weighted short position in 10-year Treasury futures contracts. STPP charges 0.75% in fees and expenses while volume is light at around 29,000 shares a day. It is an unpopular bond ETF with AUM of just $5.3 million.
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