From the May 2014 issue of Investment Advisor • Subscribe!

ETF Providers Get Ready for Rising Rates

ETF providers have the tools to build efficient fixed income portfolios

ETF providers have tools to bring clarity to the increasingly complex fixed income market. ETF providers have tools to bring clarity to the increasingly complex fixed income market.

One of the big stories these past couple of months came from Federal Reserve Chairwoman Janet Yellen's Federal Open Market Committee press conference on March 19 when she indicated that the U.S. central bank could start to raise interest rates six months after ending asset purchases, which would move the rate hike timetable up by about six months.

While no one knows with any certainty when or if interest rates will normalize, it is widely known that interest rates are low based on historical measures — and if rates are low, then prices, by definition, are high. Although prices can remain elevated for an extended period, the danger of buying high suggests that prices will soon drop, and the bond market is not immune to such an effect.

This scenario puts advisors in the position of needing to address the fixed income allocation of client accounts differently from in years past. No longer can a series of longer dated U.S. Treasuries reliably and comfortably do the job.

The ETF industry has created the tools and the opportunity for resourceful advisors to build fixed income portfolios that can provide reasonable income without taking on excessive interest rate risk. ETFs allow efficient access to strategies such as interest rate hedging and market segments like emerging market, corporate sectors, varying maturities and managed solutions.

For many years, iShares has offered different maturity ranges in the Treasury and credit spaces. IShares then took a page from the Guggenheim playbook, offering target maturity funds whereby all the bonds are held to a particular maturity in the same year and then the fund closes.

For an example of such a fund, the Guggenheim BulletShares 2018 Corporate Bond ETF (BSCI) allows an advisor to include a very specific exposure for any sized portfolio without costing the client the expense of a wide bid-ask spread on what might be a $10,000 order. Typically, the smaller the order, the larger the mark-up to buy an individual bond or mark-down to sell an individual bond.

ProShares has emerged as a leader in the hedged fixed income space with funds targeting investment-grade and high-yield bond portfolios that employ an overlay of shorting Treasury futures to protect against rising rates.

PIMCO and AdvisorShares have been progressive in the actively managed space. While actively managed funds do not assure outperformance, there will be advisors and individual investors looking to delegate at least some of their fixed income portfolio oversight to managers who make the bond market their full-time job.

Firms including WisdomTree and Market Vectors also offer emerging market bond funds, and while this raises concerns about currency exposure, many emerging market bonds are issued in U.S. dollars to make them more attractive for U.S. investors.

The key takeaway is that these strategies only previously existed for the largest market participants. ETF providers have leveled the playing field. RIAs who are willing to spend the time and opportunity to assemble sophisticated portfolios can now better help clients withstand whatever might be coming to the bond market, especially if interest rates climb.

If interest rates escalate, there will invariably be investors who get caught owning the wrong parts of the bond market. Part of that effect will stem from the entirely new paradigm that certain segments of the bond market carry the same volatility as equities or maybe even more volatility than equities.

The reality is that the fixed income market, by virtue of unprecedented Fed policy, has become far more complex than it has been in 30-plus years. ETFs can help advisors who take the time to learn and implement strategies to protect their clients from what seems like certain increased bond market complexity.

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