Interest rate and credit risk continue to invade investor portfolios looking for an appropriate hedge against equity investments.
But can these hazards be avoided despite the Federal Reserve's recent announcement to keep rates near zero but maintain its quantitative easing (QE) program? Innovative mutual fund and ETF managers think so.
Much to the surprise of industry experts, the Federal Reserve's Federal Open Market Committee (FOMC) reported in its Sept. 18 announcement plans to hold on tapering off its quantitative easing program, but stay the course for low interest rates. Markers will stay around the "target range for the federal funds rate at 0 to 1/4 percent" for the time being, the central bank statement said.
As of Sept. 17, 10-year U.S. Treasury notes were around 2.88%, according to the Federal Reserve. QE includes $40 billion in purchases of mortgage-backed securities and $45 billion in Treasury securities per month.
"Asset purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on the Committee's economic outlook as well as its assessment of the likely efficacy and costs of such purchases," according to the FOMC.
In anticipation of the Federal Reserve's announcement, taxable and municipal bond funds reported outflows last month that were around $15.5 billion and $11.7 billion, respectively, according to a Sept. 13 recap from Morningstar.
"Strong outflows from core bond funds, and municipal bonds are somewhat offset by moderate flows into short-term bond, bank loan, nontraditional bond, and equity funds," Morningstar fund analyst Michael Rawson noted.
Since the end of April, bond funds reported $81.9 billion in outflows from investors, serving as an example of low interest rates and contracting QE's reach, according to Morningstar.
When asked about what alternate bond funds have been performing well, Rawson added that "bank loan funds, also known as floating rate, benefit from improving credit and are somewhat protected against the Fed's tapering effect on interest rates."
Thanks to the reaffirmation from the U.S. central bank to maintain low interest rates, Wesley Sparks, head of Schroder Investment Management North America, Inc.'s U.S. taxable fixed-income and portfolio manager for the Schroder International Selection Fund (ISF) Global High Yield, said "investors have to ask why they are holding fixed-income."
"In some cases it may make sense to hold individual bonds to maturity," Sparks explained. "The thing is with a mutual fund there is no maturity, it can have a worse experience in the middle of a rising interest rate environment because the individual investor can't control the maturities of the bonds in that mutual fund vehicle that some manager is running."
F-Squared Investments President and CEO Howard Present agrees that holding bonds to maturity is probably the safest bet for individual bond investors today.
"I think this is the hardest time in the last 30 years to be a bond investor because you don't trade bonds, you buy bonds," Present said. "You can't be cavalier. An individual investor doing a buy and hold on just an average bond fund I think is a pretty dangerous proposition."
Because of the reported dangerous returns for Barclays Capital U.S. Aggregate Bond Index, the notable measurement for the asset class, which reported a -3.06% return for the year-to-date, Sparks suggested a strategy that layers in hedges for a credit investor as a boon for investors.
The ISF Global High Yield Fund, which mostly deals with credit risk, has 70% of its investments in securities with a credit rating below investment grade as measured by the major credit rating agencies.
With investors' "booking gains," Sparks said that one way in-flows swarmed the ISF Global High Yield Fund during the period between mid-2009 to May 2011.
The prospect of booking gains is also a goal for the F-Squared chief executive. The Wellesley, Mass.-based firm holds a "directional mandate" to participate in the market at opportune times.
"We de-risk an investment portfolio when the market has a higher probability of loss and to re-risk when the markets get healthy again," Present stated, while noting that his firm has about $15 billion in assets under management among its U.S. equity, fixed-income, international equity and real asset funds.
According to Cerulli Associates, "ETF strategists or ETF managed portfolio providers" such as F-Squared, Windhaven Investment Management and RiverFront Investment Group are growing in attraction. As of 2012, the ETF sponsors have reported a 60% growth rate in total assets under their collective watch.
Present, which notes half of his firm's assets are sub-advised mutual funds with the remainder being separately managed accounts, said that fixed-income investing is in need of an innovative approach.
"If you look at fixed-income, some of those ETFs are sensitive to credit markets like high yield, but some of those are sensitive to interest rates like investment grade bonds. We have a product that can de-risk in the event of concerns around credit or in the event there are concerns over rising interest rates," Present stated.
"We're pretty bearish on bonds, both on interest rate risk and credit risk, that we've gotten out of the whole shooting match," he said.
With an interest of combining eight stock and bond ETFs, the AlphaSector Multi-Asset High Income Index (MAHI) is F-Squared's attempt to answer client demand that may have been hurt from a simple high yield ETF investment.
The fund is "designed to provide high current yield and still provide the kind of downside protection that people have been used to when buying bonds."
"The bigger kicker I think in the industry today is not the fact that the stock markets can lose money, we've known that for a long time, that's not new news," Present said. "The real change in the equation that has made life difficult for investors is high quality bond yields dropping down to the 3% level or less."