Playing Defense on Bonds

The recent bull market in bond prices has been called the biggest bond bubble in history. Thanks to a combination of stock-averse investors and multi-billion dollar purchases of U.S. Treasuries by the Federal Reserve, higher bond prices have fueled the boom. But what happens when the trend reverses? How can advisors shield clients from the bond market’s eventual fall?

All bonds have three main risks: credit, currency and interest rate risk. And to some extent, bond ETFs can help to reduce these risks, particularly in diversifying away from single bond issues. However, even with broadly diversified bond funds, rising rates can severely damage bond values.

Let’s examine defensive bond strategies for staying ahead of the pack.

Rates and Durations

How can advisors estimate the potential damage of rising interest rates on a bond portfolio? Eric Jacobson, a fixed income analyst at Morningstar, says to focus on bond durations.

To estimate the level of interest rate sensitivity on a bond portfolio, Jacobson uses a simple formula that multiplies a bond’s duration by 1%. For instance, if interest rates were to rise by 1%, it would mean bonds with duration of 2.5 years should lose around 2.5% in value.

Jacobson warns that his formula for estimating bond losses is just a mathematical construct and doesn’t necessarily account for changes in interest rates in every scenario. While the formula can sometimes be thrown off because shorter-term interest rates move up while longer-term rates move down—or other oddities—he says the formula is still a good barometer of what an investor can expect in a scenario of interest rate spikes.

Looking Abroad

Europe’s sovereign debt crisis has highlighted the danger of concentrated credit risk. Rather than investing in government debt from just one country, some advisors are opting for diversified bond exposure to multiple countries, including emerging markets (EMs).

“I think EM debt and high yield is moderately overvalued, not grossly so,” says Herb W. Morgan, CEO and chief investment officer of Efficient Market Advisors in San Diego. “There are pockets of EM debt in particular that look attractive, specifically EM-denominated corporate.”

The SPDR BofA Merrill Lynch Emerging Markets Corporate Bond ETF (EMCD) tracks U.S. dollar-denominated emerging markets corporate senior and secured debt publicly issued in the U.S. domestic and Eurobond markets. The fund carries a 30-day SEC yield of 3.54% and charges annual expenses of 0.50%.

Local-currency EM bond ETFs also offer another opportunity to diversify credit risk along with currency risk. These types of funds invest in emerging market sovereign debt that is publicly issued and denominated in the issuer’s own domestic market and currency. This feature adds a level of currency diversification, away from the U.S. dollar.

For advisors concerned about the threat of inflation, the iShares Global Inflation Linked Bond ETF (GTIP) could be a good choice. Rather than using a U.S. TIPS-focused fund, which exposes the investor to credit risk concentrated on the U.S. government, GTIP owns TIPS from a basket of various countries, including Canada, France and the United Kingdom. Diversifying credit risk with an ETF like GTIP is easily accomplished.