Q3 ETF Playbook for Bond Investors
As monetary policy uncertainty continues to stoke rate volatility, look for strategies with lower rate risks than broad core bonds. Meanwhile, positive rating trends, fundamental growth, and a growing economy support taking on credit risk — even with spreads tight.
Balance Risks and Opportunities with Short-term Core and Credit Strategies
Uncertainty over Federal Reserve (Fed) policy has led to elevated rate volatility for core aggregate bonds, a market segment still trading at losses year to date. With a data dependent Fed, a crowded macro calendar, and key economic data more variable relative to expectations, it’s likely this increased rate volatility will continue.
But credit is not witnessing the same level of volatility. Foundations for its year-to-date gains are underpinned by sturdy economic growth, improving earnings fundamentals, and positive ratings momentum. Spreads, however, are noticeably tight. And while that can be cause for concern, historically, returns have still been positive over the next 12 months at these current levels.1
With a favorable outlook for credit set against a backdrop of policy-related rate volatility presenting challenges for broad core bond exposures, consider:
- Actively managed floating rate loan strategies that seek to limit rate volatility, without sacrificing income potential by focusing on high yielding below investment-grade markets
- Short-term active core strategies to pursue more yield with less volatility than core bonds by balancing exposure to rate and credit-sensitive sectors
- Balanced high-quality intermediate investment-grade bonds to take on more fairly-compensated credit and rate risks, given yield, duration, and spread profiles relative to core bonds
- Equity sensitive convertible credit strategies to overlay an implicit equity bias on top of a credit exposure, for greater alpha potential than traditional aggregate bonds
Rates to Remain Higher for the Summer
Given CPI’s limited progress toward the Fed’s 2% target after significant declines in 2023, the Fed anticipates keeping rates elevated for longer than previously expected, with just one cut now forecast in 2024.2 Recent FedSpeak from San Francisco Fed President Daly confirms this view, as she acknowledged progress on taming inflation but also declared “we are not there yet.”3
The July Fed meeting is unlikely to be a showstopper, but August’s Jackson Hole Symposium may provide more information on how patient the Fed is willing to be, until they “get there.” Nevertheless, the Fed’s current patience should keep short-term rates, like the US 2-year yield, pinned close to the fed funds rate, limiting the slope of the curve. In fact, consensus economic forecasts have the differential between the US 2- and 10-year remaining inverted until Q1 2025, with the 3-month and 10-year differential not having an upward slope until at least Q4 2025.4
Futures implied forecasts indicate the Fed’s potential first cut could be at the November meeting. But that projection is likely to jump around for non-economic reasons. The Fed’s November meeting takes place a day after the US presidential election — a macro event that may not be clearly resolved by the time the Fed meets, if the last presidential election is any indication.
Big picture? The curve will likely remain inverted for a bit longer, as long as short-term rates remain high. Some rate cuts may occur by year end. But the timing of any cut is clouded by events out of the Fed’s control, as the calendar works against them and sparks more rate volatility.
Uneven Data Trends Further Cloud Rate Risks
The data dependent Fed will be challenged by the increased variability of key economic data releases. Variability stemming from changes in consumption, employment, and social behaviors during the pandemic have made forecasting economic data accurately more difficult. Large payroll report misses are on example of this, with the most recent report exceeding all economists’ estimates.5
Alongside make-or-break CPI prints, these variable data releases present challenges for policy watchers — as well as bond investors. These challenges are underscored by long-term US Treasury bonds’ rolling 90-day standard deviations of returns (12.5%) that are greater than US equities’ (10%).6 Typically, perceived safe-haven long-term US Treasurys have a realized volatility that is five percentage points less than stocks.7 Not so in this new rate risk regime.
Core bonds are experiencing a similar trend. While not greater than stocks, their own standard deviation of returns over the past 90 days plots in the 87th percentile over the past 30 years.8 In fact, this latest bout of realized rate risks is immersed in a longer bond risk trend. Bonds’ rolling 90-day volatility has averaged in the 91st percentile for all 2024 and has been significantly elevated each of the last few years (Figure 1).
Credit Foundations Are More Stable
The same healthy economic signs that led to rate cut repricings have helped support credit exposures. In fact, five tailwinds underpin the case for credit:
- A growing economy: A healthy labor market, resilient household demand, and business investment fueled a 2.6% real rise in final sales to private domestic purchasers. This key gauge of underlying demand has been above 2% for three consecutive quarters.9
- Positive earnings growth: After a string of negative quarters, earnings for US equities are poised to record their fourth consecutive quarter of growth.10 Earnings growth is projected for all of 2024 and for full-year 2025.
- Improving ratings momentum: After downgrades outpaced upgrades for seven consecutive quarters, the upgrade-to-downgrade ratio finally moved above 1 (indicating more upgrades than downgrades) in Q2. Positive ratings momentum indicates improving overall credit fundamentals, a trend also reflected in improving debt coverage ratios for below investment-grade issuers11 (Figure 2).
- A healthy coupon: High yield bonds yield around 8%, while senior loans yield above 9%12 — greater than their own historical averages and today’s core bonds’ yields.13
- Supportive technical: High yield issuers have brought $164 billion of new issuance to the market, a 77% increase to the amount raised through the first six months of 2023.14 And in US investment-grade, that market is running 30% above last year’s first half issuance pace — indicating firms are seizing on strong investor demand for the carry associated with credit.15
Tight credit spreads are cause for concern. For both high yield and investment-grade corporate bonds, spreads are approximately 40% below their historical averages and plotting in the lowest quintile over the past 20 years.16 Yet, our research shows that the starting spread level and the subsequent 12-month returns reveal mixed relationships.
Rather than showing a linear relationship, with the lowest returns coming when spreads are in the bottom quintile and the best returns coming when spreads are in the top quintile, returns show more of a “smile” pattern (Figure 3). In fact, quintile one’s (today’s) starting spread level returns are higher than quintiles two or three for investment-grade corporates.
Active and Convertibles for Uneven Rate Risks and Conducive Credit Trends
Elevated rate risks alongside conducive credit trends support using credit-related strategies with the potential to limit rate-induced price swings. Expressing a bias to credit can take many forms, however.
Figure 4 illustrates the yield, duration, volatility, and yield-per-unit-of-volatility ratio profiles of short-term bond sectors to help you decide how to pursue today’s credit opportunities in an evolving rate risk regime.
Active strategies’ flexibility to manage rate risks while pursuing opportunities amid a broader universe may be the most beneficial approach in the core. Moreover, duration-controlled active strategies that combine both traditional (e.g., investment-grade corporates and US Treasurys) and non-traditional bond sectors (e.g., CLOs, securitized credits) can support tactical positioning along the yield and credit curve.
An actively managed senior loan strategy can also help limit rate risks, without sacrificing income. Due to their floating rate coupons, senior loans have minimal interest rate risk, resulting in realized volatility of just 1.98% versus the Agg’s 6.79% over the past year.17
Since senior loans are below investment-grade rated securities, this reduction in rate risk doesn’t constrain their potential for income generation. Yields are above 9%, leading to a yield-per-unit-of-duration more than four times that of core bonds and almost three times that of fixed rate high yield (Figure 4). And active strategies’ prudent risk management and sector and security selection may help navigate a credit market with healthy fundamentals and supportive technicals, but rich valuations.
Balanced credit strategies can also be found within investment-grade markets. High-quality investment-grade corporate bonds with maturities between 1 and 10 years, leading to a weighted duration of four years, allow investors to take on some duration risk, but with a better balance toward income. The segment’s 5.41% is greater than core bonds’ 5.07% and on par with broad corporates’ 5.5%.18
With elevated rate risks alongside conducive credit trends and low levels of equity volatility, turning to non-traditional hybrid strategies like convertible bonds may provide alpha opportunities that are not correlated with traditional bond characteristics.
Convertible securities now trade in a balanced range, neither overly equity-sensitive nor bond-like, based on a current delta of 47.19 Convertibles’ historical delta is 65, and pure equity sensitive coverts have deltas above 70, indicating the broader convertible market may have potential upside if the equity markets remains well behaved.20
Convertibles also carry a low duration (1.8 years) and nearly half of their exposure is allocated to Tech and Communication Services firms — two sectors driving equity returns.21 Issuance is also supportive, as the $47 billion in primary market volume this year is only five billion behind full-year 2023 figures.22 We’ll likely see the most issuance since 2021, as firms turn to alternative forms of financing operations amid elevated rates, creating more opportunities for investors to express a different form of credit risk.
Implementation Ideas
Consider the following bond ETFs to implement the strategies discussed above:
For actively managed floating rate loan strategies: SPDR® Blackstone Senior Loan ETF [SRLN]
For short-term active core strategies: SPDR® DoubleLine® Short Duration Total Return Tactical ETF [STOT]
For balanced high-quality intermediate investment-grade bonds: SPDR® Portfolio Intermediate Term Corporate Bond ETF [SPIB]
For equity sensitive convertible credit strategies: SPDR® Bloomberg Convertible Securities ETF [CWB]