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5 Bond ETFs for a Rate-Proof Portfolio

Treasury yields have been on the rise in recent weeks on growing riskier appetite, expectations of tightening policies and improving economic fundamentals. Notably, 10-year yields jumped to 2.428% — the highest level since Mar 31.

Inside The Surge

Speculation is rife that the new Fed Chair will follow aggressive monetary policy tightening in 2018. Additionally, the Senate’s passage of the $4.1 trillion budget paves the way for tax cuts. This is putting further pressure on the bond market, pushing yields higher (read: 5 Biggest ETF Winners of Trump Trade Resurgence).

Rounds of upbeat data also led to a spike in yields. Manufacturing activity, as measured by the Institute for Supply Management, reached a 13-year high in September while non-manufacturing activity or the service sector expanded to the highest level since Aug 2005. Additionally, auto sales strongly rebounded in September posting the best month of the year, following the eighth consecutive month of decline. Consumer confidence soared to highest level since 2004 in early October, per the preliminary University of Michigan reading.

Moreover, the buzz that European Central Bank will scale back its €60 billion in monthly bond purchases in its meeting on Thursday and risk-on trade have also contributed to the increase in yields.

Given 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. Below we highlight five bond ETFs that could be great picks in the rising rate environment.

Floating Rate ETFs

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 with 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 iShares Floating Rate Bond ETF FLOT, which follows the Barclays US Floating Rate Note < 5 Years Index. Holding 559 securities, the fund has an average maturity of 2.05 years and effective duration of 0.15 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 81.5% of them rated A or higher. The product has amassed $6.5 billion in its asset base while trades in volume of 814,000 shares per day on average. Expense ratio comes in at 0.20% (read: 5 Winning ETF Strategies for Q4).

Senior Loan ETFs

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 these 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 classes.

The most popular and liquid fund in this space is PowerShares Senior Loan ETF BKLN with AUM of $8.8 billion and average daily volume of about 3.3 million shares. The fund tracks the S&P/LSTA U.S. Leveraged Loan 100 Index and holds 121 securities in its basket. It has average maturity of 5.25 years and days to reset of over 22. The product charges 65 bps in fees a year.

Ultra-Short Bond ETFs

Higher rates might lead to huge losses for investors who do not hold bonds until maturity. As a result, short-duration bond ETFs like PIMCO Enhanced Short Maturity Active Exchange-Traded Fund MINT are less vulnerable and act as better hedge to rising rates. The fund is actively managed and seeks to manage interest rate risk while maximizing current income through diversified exposure to short-term investment grade bonds. It holds 642 securities in its basket, with average maturity of 0.46 years and effective duration of 0.45 years. The product has accumulated $7.6 billion in its asset base while trades in a solid volume of around 523,000 shares a day. It charges 36 bps in annual fees (see: all the Money Market/Ultra-Short Term ETFs here).    

Negative Duration Bond ETFs

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 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, of which WisdomTree Barclays U.S. Aggregate Bond Negative Duration Fund AGND has AUM of $17.4 million and average daily volume of nearly 2,000 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 comes in at 0.28% (read: Fed to Tighten Policy: Bet on These ETFs).

Zero Duration Bond ETFs

Like AGND, zero duration bond funds also combats rising interest rates through similar concept. WisdomTree Barclays U.S. Aggregate Bond Zero Duration Fund AGZD 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 $24 million in AUM and trades in a light average volume of almost 3,000 shares per day. It charges 23 bps in annual fees.

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PWRSH-SNR LN PR (BKLN): ETF Research Reports
WISDMTR-B USABN (AGND): ETF Research Reports
ISHARS-FL RT BD (FLOT): ETF Research Reports
WISDMTR-C USABZ (AGZD): ETF Research Reports
PIMCO-E SMETF (MINT): ETF Research Reports
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