Indexology^® Blog

Bond Ladder ETFs are providing a unique solution for managing duration risk. These ETFs, now available for the municipal, corporate and high yield sectors, enable more precise control over duration risk than previous fixed income ETF offerings. Moreover, they have performance benefits relative to traditional fixed income index funds and ETFs if the rising rate and steep slope yield curve environment persists.

In addition to delaying the onset of tapering, the September FOMC (Federal Open Market Committee) meeting and communications have clarified the timing of any future hikes of the Federal Funds rate. The message is clear – we should remain at nearly zero for an extended period of time, perhaps years.

Absent any potential data-dependent alterations, the short end of the taxable yield curve should remain anchored.  Therefore, most bond market yield curves should remain steeply sloped. Returns to taking on additional duration risk should remain elevated. But, as we’ve learned since last July (and in 1994 and 2004), long rates accelerating higher can prove immensely damaging to principal. Taking on additional duration risk from holding longer maturity debt can be risky.

This environment emphasizes that investors need to make suitable and precise choices for duration risk.  Unfortunately, most bond market index funds and ETFs attempt to match duration to a bond index.  In a rising interest rate environment, these funds have to continually add duration (longer bonds) in order to match their benchmark duration and replace expiring or called shorter issues. Unfortunately, the bonds they add to the index are also the bonds where the duration risk is concentrated. These funds cannot “roll down the curve”, or capture the duration risk premium as average maturities decline with time.

Several ETF sponsor firms offer a new class of fixed income fund that only invests in selected maturities.  In these bond ladder ETFs, all of the underlying investments are concentrated in a selected maturity window (e.g., 2018 investment grade corporates or 2017 municipals). This new type of bond fund offers the ability to tailor duration risk and sector exposure to match risk and return objectives.

Since bond ladder ETFs are designed to mature, you can stack them together in an arrangement that resembles a traditional, but more diversified, bond ladder (hence the term Bond Ladder ETFs).  By stacking the ETFs, you own multiple highly-diversified baskets of underlying bonds. Just like equity ETFs, one of the prime advantages of fixed income ETFs is diversification. Since the ETFs trade like equities, an investor (particularly smaller advisors, institutions and firms) do not need to deal with the headaches of individual bond trading. Trading odd lots is a treacherous and frequently unprofitable undertaking for most smaller investors.

In this steep yield curve environment, the Bond Ladder ETF structure offers a unique solution to adding diversification to the traditional bond ladder. Having precise control over sector exposure and duration risk could prove rewarding if the current fixed income dynamic looks likely to persist.

S&P Dow Jones Indices is an independent third party provider of investable indices.  We do not sponsor, endorse, sell or promote any investment fund or other vehicle that is offered by third parties. The views and opinions of any third party contributor are his/her own and may not necessarily represent the views or opinions of S&P Dow Jones Indices or any of its affiliates.

What drives the success of some index commodities like Brent Crude Oil or Milling Wheat to become global benchmarks? Can the energy revolution in the U.S. change the way the world views benchmarks such as WTI Crude Oil or Natural Gas?

To find out the answers, we recently had the special opportunity to interview Gary Morsches, managing director of global energy at the CME Group, Nicholas Kennedy, head of business development of commodity derivatives at NYSE Liffe and Mike Davis, director of market development for ICE Futures Europe.

Nick and Mike discussed some key points in common across some commodities that have enabled the transition from a local to a global benchmark. According to them, the first role of a commodity futures contract is to be a hedging tool of the physical commodity, and it should be representative of where the traders are located. Initially, all futures contracts serve a local region where the commodity is produced, then consumed nearby.  If there is infrastructure in place to deliver throughout many regions, promoting global usage, then the commodity has a chance of becoming a global benchmark as long as it is being consumed across the world. The focus then needs to remain on the key users since the moment they stop consuming the commodity, its representation of a global benchmark will collapse. This reverts back to the first role of the futures contract where it is used to hedge the physical exposure. If the physical market disappears, then the relationship underpinning the commodity futures market is gone.

In our discussion with Gary, he mentions two key factors changing the landscape of energy today.  Simply, he agrees with Nick and Mike that logistics are imperative to the global growth of the locally produced crude oil in North America. However, he dives into some detail about pipeline reversals, new pipelines and railroad transportation as important infrastructure developments.  The second major game-changer he mentions is the technology that is increasing the production from the US and Canada. It is effectively backing out all of the crude imports into the US, creating self-sufficiency and changing the crude flows worldwide. Not only is the technology changing the price of crude but it is impacting the prices of refined products, final products and natural gas.  So far, the price setting is spreading throughout Central America, South America and Europe, setting the stage for a global shift that could result in an index impact via constituents and weightings according to the rules in the methodologies.

In real estate, it’s location, location, location.  In bond portfolios, it’s duration, duration, duration.

With the onset of defined maturity or “target date” ETFs, investors now have the ability to tweak their portfolios to their liking.  Muni , taxable and high yield offerings are now available in the market place, enabling investors to essentially “ladder “ their portfolios with ETFs that will “mature” in different time frames or years (i.e. 2014, 2015, etc.)  Essentially, target date ETFs are a re-branding of fixed income unit trusts that existed years ago in the marketplace.  Just as many “managed” ETFs rebranded themselves from their former name as closed end funds.

Currently, the yield curve offers very little reward for short-term returns.  Investors have an appetite for yield but also realize that the interest rate and duration risk of longer maturities could give them indigestion.

“Barbelling” a portfolio worked for many years where there was a balance between the short-end of the curve on the left side of the barbell and longer maturities invested on the right side.  When the investor “lifted” the barbell over their head, there was balance between both ends, making it easier to hold.  Now, investors have started to skew the left side, or shorter end of the curve in their barbell, making many investors feel uncomfortable with the lack of balance over their head.

Target date ETFs could be a great tool in the future on the short-end of the curve when rates normalize.  Duration measures the sensitivity of a bond portfolio to a change in interest rates.  However, currently, extra low duration bonds and ETFs offer little more than cash for taxable and muni ETFs.  High yield, or junk offerings in ETFs, offer higher reward with commensurate risk.  An equally weighted portfolio of corporate target date ETFs in years 2014, 2015 and 2016 had a duration of just under 2 years and a mean yield of under 1%.  Since many retail investors and endowments “eat their cash flow”, this strategy would still leave them hungry.   Since target date ETFs “mature”, cash accumulates as bonds mature. In this interest rate environment, investors might be better served looking at the near-zero rate of return in cash or possibly utilizing ultra-short maturity ETFs, even though the latter should not be viewed as a cash alternative.

S&P Dow Jones Indices is an independent third party provider of investable indices.  We do not sponsor, endorse, sell or promote any investment fund or other vehicle that is offered by third parties. The views and opinions of any third party contributor are his/her own and may not necessarily represent the views or opinions of S&P Dow Jones Indices or any of its affiliates.

The S&P Municipal Bond Puerto Rico Index is down over 16% since mid-year and over 20% for the last 12 months.  The ‘storm’ has continued into October as the index is down 2% month to date.

The Puerto Rico bond market debacle weighs on the rest of the municipal bond market despite its relative high quality. For the year to date, tax-free investment grade municipal bonds tracked in the S&P National AMT-Free Municipal Bond Index are down over 3.5% as yields have risen by about 100bps. (As a comparison, investment grade corporate bonds tracked in the S&P U.S. Issued Investment Grade Corporate Bond Index are down just about 2.5% as yields have risen by about 50bps).

A quick look at the quality of investment grade municipal bonds compared to the corporate bond market can be seen in the graph below.

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For most investors and many economists the first Friday of the month means the Employment Report at 8:30 AM eastern time.   The much-watched first official bit of economic data for the month just ended sets the tone for the markets and for the weekend investment advice columns.   This weekend the economic-investing blogosphere had little to debate beyond what to watch instead of the unemployment rate.  Those hoping that all will be revealed in the next Employment Report once the government is back to work could be disappointed.  On the usual schedule the Bureau of Labor Statistics would be doing their survey this coming week.  If the government is still shut down next weekend, we might have to wait even longer to argue over the accuracy of the unemployment rate.

Don’t despair.  Investors may be better off with fewer economic statistics and a little less debate.   Some years ago an academic paper title “Trading is Hazardous to Your Wealth” showed that for many individual investors, the more often they traded, the worst their results were.  Portfolio turnover averaged 75% for the investors studied and their returns lagged the market by a substantial margin.  The authors of the study suggest that investor over-confidence drove the excessive trading. (The paper can be found here.)

Other research that shows index investing outperforms some 60%-70% of active fund managers is based on buy-and-hold investing.  In the analyses the index fund is assumed to be held for one, three or five years with index level minimal turnover while the active fund manager trades, often surpassing the 75% turnover noted in the Trading is Hazardous study.  All that churning drives up costs. If the trading is successful, the churning also drives up tax liabilities.  Those costs are a key factor in the studies results.  (Index vs. active research is here.)

Most of us would like to see the government get back to work – after all we’re still paying our taxes so they should be doing something for our money – and most would not want to go without ever seeing another economic statistic or unemployment rate report.   But for the moment maybe we can enjoy worrying about something else this weekend.