One fierce topic of debate among fixed-income investors is the Federal Reserve’s ultimate withdrawal from quantitative easing. This momentous event would mark an end to open market purchases of treasury and agency mortgage backed securities. Although guidance has led investors to believe it could occur in 2015, the statistics monitored by the Fed are far more dynamic, and subject to interpretive change.
Interestingly enough, there is little evidence in 2014 to suggest that reducing asset purchases will result in a knee jerk reaction to higher interest rates. However, if the economy and labor markets continue to strengthen, and quantitative easing ultimately comes to a close, the Fed could begin to tighten its monetary grasp and raise short-term interest rates to combat inflation. This could eventually lead to further steepening in the yield curve and more trouble ahead for fixed-income investors in intermediate and long-term bonds. For this very reason, investors should be vigilant in monitoring core allocations to traditional aggregate bond funds over the next several years.
In this scenario, there is one key driver of bond market volatility investors should concern themselves with when it comes to evaluating their bond funds: Duration. Duration is an estimate of the sensitivity of bond prices to incremental changes in interest rates. For example, a bond fund with an effective duration of 10 years will react similarly to a 10-year Zero Coupon Treasury note when interest rate changes occur.
If you were to evaluate a hypothetical 10-year, 2.75% U.S. Treasury bond with an estimated duration of 8.81 years, a jump to 3.75% would result in an unrealized mark to market loss of approximately 8.3%. Three years of coupon payments would need to be earned to catch up with the price decline assuming rates remain the same. In general, when examining investment grade bonds, the greater the duration, the greater the bond’s price will change in relation to interest rates.
When an investor owns a broadly diversified bond portfolio, such as the iShares Core Bond ETF (AGG) or the Vanguard Total Bond Fund (BND), they own a basket of thousands of individual bonds with the vast majority of securities maturing between one and 30 years. Owning a fund with all those bonds are great for diversifying away issuer risk, however, duration risk doesn’t diversify, it simply averages across the portfolio.
The weighted average duration of these portfolios is 5.26 and 5.5 years respectively. This significant duration risk can become a problem when a swift increase in interest rates takes place, similar to what we witnessed after the market’s response to the Fed’s initial taper in late May 2013. Investors were left clamoring to make changes to long duration bond holdings at the most inopportune moment.
Traditional Index-based strategies like AGG have seen a significant increase in duration risk over time due the lengthening of average maturities in the indexes it seeks to track. Investors who previously selected an aggregate product for their fixed income allocation could be unpleasantly surprised by the change in duration risk over time and the commensurate increase in risk.
A more strategic approach to avoid the headache of reactionary allocation changes in a declining market is the use of Maturity Bond Funds. These products are bond funds that act like bonds, allowing investors to better manage duration risk, just like individual bonds, but without the concentration risk associated with purchasing individual bonds. These products deliver bond-like performance because each portfolio invests in bonds with a specific year of maturity, seeks to hold these bonds until their eventual redemption and then liquidates and returns the capital to investors.
To be clear, all bonds are marked to market daily, however, the redemption feature of individual bonds and Target Maturity Bond Funds provide the investor with an option to earn their estimated yield and reinvest maturing proceeds at redemption, effectively ignoring the daily fluctuations of the market. Additionally, both Target Maturity Bond Funds and individual bonds decline in duration as the bonds approach maturity; thereby decreasing the sensitivity to interest rate changes over time, making them ideally suited as building blocks of a laddered bond strategy.
For example, an investor can create a bond ladder by purchasing equal parts of a selection of the Guggenheim BulletShares Suite of Corporate Bond ETFs (2014-2022 maturities) or the iSharesBond Suite of Corporate Bond ETFs (2016,2018,2020,2023 maturities) and create laddered portfolios that deliver the benefits of diversified funds, but also can be held to maturity.
In comparison, aggregate indexes are designed to purchase and sell bonds in perpetuity, never holding bonds to their eventual maturity, never maturing themselves, and always maintaining a perpetual duration. Investors in these products must pay close attention to the current composition, the daily price fluctuations of the portfolio and the mood of the market to ensure the benefits of the investment are realized.
The real world practicality of Target Maturity Bond Funds, alongside low duration held to maturity indexes can also be applied to lower levels of the credit spectrum through the use of Target Maturity Bond funds such as the Guggenheim BulletShares 2017 High Yield Corporate Bond ETF (BSJH). An investor can efficiently commingle a mix of investment grade and high yield ETFs to enhance income, manage duration, and diversify portfolios of highly rated bonds during a strengthening economy or steepening yield curve.
Investors switching to Target Maturity Bond Funds from aggregate bond products will need to alter their investment style as Target Maturity Bond Funds do require ongoing maintenance as investment capital is returned over time. In addition, expense ratios can range from a comparable 0.10%, to an additional 0.45% of investment cost over traditional aggregate strategies.
However, when compared to losing (duration) control and the potential for losses during a rising rate environment, it becomes clear that investors could be well served implementing a laddered bond strategy using individual bonds and Target Maturity Bond Funds. More complex portfolios can target specific credit qualities or yield curve objectives, and if the market shifts, changes to the key characteristics can be made to one or more ETFs within the portfolio. This enables an investor to fine tune their portfolio, instead of being faced with selling a single fund, losing their income stream, and then rebuilding from scratch after the dust settles.
Understanding the risks associated with an aggregate fixed-income portfolio, researching the tools to avoid those inherent risks, and implementing a duration targeting strategy could insulate you from what lies ahead, despite the Federal Reserve’s best intentions. The future direction of interest rates is largely unknown, but knowing how your portfolio will react to them will prove useful even if the fixed-income landscape remains calm.
This article was originally published on Forbes.com.