Tag Archives: fixed income

Fed Ready? New Sit ETF Hedges Hikes In Interest Rates

Nobody should invest in bond exchange traded funds without understanding that when interest rates increase, the bond’s price declines. With significant improvements in the economy and unemployment rate, the Federal Reserve is expected to raise rates before 2015 ends. This will affect securities across the entire bond market.

So, what is a bond ETF investor to do? A new exchange traded fund from ETF Managers Group seeks to help investors hedge rising interest rates by using a concept called negative duration that actually creates price appreciation when interest rates advance.

Sit Rising Rate ETF (RISE) holds a portfolio of futures and options contracts weighted to achieve a targeted negative 10-year average effective portfolio duration. Because it holds futures, the ETF is structured as a commodity pool.

Sam Masucci, founder and chief executive of ETF Managers Group, said the ETF should be used as a hedge, or insurance, to protect a bond portfolio from interest-rate volatility. “A small allocation of 10% to 20% in RISE can significantly reduce the interest rate risk within a bond portfolio.”

Duration calculates a bond’s sensitivity to interest-rate volatility. It measures how much the price of a bond is expected to fall when interest rates rise 1% — and rise when rates fall 1%. The longer the duration, the greater the interest rate risk. Negative duration determines how much the price will go up when rates rise. RISE tries to get a 10-to-1 ratio. So if rates rise 1%, the price should go up about 10%.

Bryce Doty, the senior fixed-income portfolio manager at Sit Investment Associates, manages the ETF based on the Minneapolis firm’s strategy.

Where RISE Fits In

Doty said an investor with a bond portfolio with an average duration of four years might choose to sell 20% of the portfolio and invest that money in the negative 10-year duration ETF. This cuts the interest rate risk by almost 70%.

The ETF achieves this effect by holding only four positions. Focused on the risk to short-term rates, 85% of the ETF’s portfolio is in short positions tied to 2-year U.S. Treasury and 5-year U.S. Treasury futures contracts. It also buys a put option on the 10-year U.S. Treasury futures contract. This means if rates rise on the 10-year note, the ETF gets price appreciation. But if rates fall, the EFT is only out the price of the put.

Compared with bond index ETFs, which typically charge expense ratios of less than 10 basis points, RISE, which is an active ETF, charges an expense ratio of 50 basis points. With other expenses factored in, the true cost can rise as high at 1.5%, although the fund is targeting a cost around 85 basis points.

“When you rebalance every month and short new Treasury futures to get target duration, you might get a tax hit at the end of the year,” said Thomas Boccellari, an analyst at Morningstar. “The benefit of the active management is, you pay the manager to control the duration for you and to get it right. But you need to understand that you are giving up a lot of yield to get this product and you need to be sure that is what you want to do.”

Two negative duration ETFs tracked by ETF.com are WisdomTree Barclays U.S. Aggregate Bond Negative Duration Fund (AGND) and WisdomTree BofA Merrill Lynch High Yield Bond Negative Duration Fund (HYND) has $32 million in assets, average daily volume of about 11,000 shares, an expense ratio of 0.28% and is up 0.44% year to date. HYND has $6.5 million in assets, average daily volume of about 9,000 shares, a 0.36% expense ratio and is up 2% this year.

Originally published in Investor’s Business Daily.

ING Offers Positive Outlook for 2012

Europe, Shmeurope. If you looking for good news, ING has it.

“Don’t listen to noise coming out of Europe,” said Douglas Cote, chief market strategist of ING, at a press conference Wednesday where the firm offered its outlook for the new year. “The [European Central Bank] will be forced to jump in. I expect an end-of-year rally.”

Paul Zemsky, ING’s chief investment officer of Multi Asset Strategies, says while Europe may suffer a mild recession in 2012, the U.S. will experience tepid growth between 2% and 2.5% With housing weak and the Federal Reserve not raising interest rates until 2013, he says inflation won’t be a problem, staying around 2%. However, he says this growth won’t be enough to bring down the unemployment and if per-capital income remains stagnant, this could cause some social unrest. And while the housing sector has bottomed out, he says it may take another year before the market begins to see a sustained recovery. The main risk to the U.S. economy is the contagion of a European slowdown.

Still companies continue to post record profits, keeping expenses low by not hiring new workers. Zemsky expects the S&P 500 to surge 9% by the year’s end to 1325, and again to 1450 by the end of 2012. “Unless,” he adds, “ Europe blows up.”

You can track the benchmark with the largest ETF in the world, the SPDR S&P 500 (SPY).

“How can you not be in the market with earnings hitting record highs?” asked Cotes, suggesting market fundamentals will continue to be strong in the face of rising global risk. In addition to rising corporate profits, he sees U.S. manufacturing expanding and retail sales at their highest levels after seven consecutive monthly increases. “As far as eye can see we see positive quarters.”

Mid-capitalization stocks are the “sweet spot of the economy,” he says, because they have the financial wherewithal of large-caps and the growth of small-caps.” He also like emerging market stocks and global real estate investment trusts.

For mid-cap stocks take a look at SPDR S&P MidCap 400 ETF (MDY).

As for those global risks, Cote says Europe’s “bank recapitalization plan is an effective fence around the crisis.” In addition, if China begins to experience a slowdown, South Korea and Turkey will pick up the slack.

Really?

The Institute of International Finance said the recapitalization plan has “serious problems” that will hurt economic growth.

Meanwhile, China is one of South Korea’s major trading partners. If China stops buying South Korea is going to have to find a lot of other clients just to break even.

Christine Hurt sellers, ING’s fixed income chief, continued the trend of discounting Europe, “there are a lot of good opportunities, unless you think there will be a massive global recession.” U.S. companies are well prepared for any credit crunch because they have nearly $1.5 trillion in cash on their balance sheets.

She likes high-yield bonds, because spreads are wide, but not consumer cyclicals. She also recommends buying sovereign debt in emerging markets. With emerging markets seeing inflation declining and credit quality increasing people should “take advantage of the shift in liquidity out of Europe.”

She expects the ECB to come save the euro zone, but if you wait until the ECB acts, it will be too late. Because there is very little liquidity in the credit markets, she says you need to buy bonds you are willing to hold for a long time.

I wasn’t very satisfied with their optimistic answers about Europe’s problems. Even though the ECB is the chief monetary authority for counties that use the euro, European Union treaties forbid it from being the lender of last resort for member countries. And as Roubini said last week, that’s not going to change.

Hurtsellers said Italy’s high bond yields are worrisome and if Italy doesn’t get enough tie to restructure, the whole thing could balloon out of control. If that happens, “market’s can create their own chaos and we’ll see more pressure on Germany.”

Zemsky added that while the ECB has remained out of the picture in terms of directly financing governments, if the European banking system seizes up, the ECB would supply quantitative easing. Why did he think that? “Because in 2008, the Fed stepped in to where we never would have expected it before, but they did it to save the world.” True, but the Fed had the power to do that and the ECB doesn’t.

“The ECB will stand behind a bank if they have enough collateral. If that doesn’t happen,” said Zemsky, “that’s the worst case scenario and will lead to a much worse recession of possibly negative 4% gdp growth in Europe.”

That should put our minds to ease.

Cautious Forecast for Next 6 Months

Pardon the obvious, Wall Street is a pretty bullish place. So, it’s refreshing to hear someone down there actually say things don’t look so good.

Ed Keon is one of the few.

“There remains a high level of caution and pessimism in the country among the average consumer and business executive,” said Keon, managing director and portfolio manager for Quantitative Management Associates. He spoke Tuesday at Prudential’s 2010 Midyear Market Outlook panel, the one with the tantalizing title: “Will the economy double-dip?” He added, “There’s plenty of money to invest, but people are reluctant to do so.”

He says the stock pullback is a symbol of not just the economic activity, but also a malaise among the American people. But he believes stocks represent a good value, compared to the long-term bond. The dividend yield for the S&P 500 Index is 2%. Considering that a quarter of the index doesn’t pay dividends, many of the stocks in the index are paying 3% to 6%, compared to the 10-year bond’s yield of 2.9%. When you can get a better return from risky large-cap stocks than Treasury’s you know stocks are cheap. Remember, prices move inversely to yield. So as prices move lower, yields rise.

For a full explanation of the relationship of yields to prices and dividends, check out Dividends Stocks for Dummies.

Not only are stocks cheap, but earnings are strong and will come in above expectations, said Keon. Still he cautions again the expectation that stocks will see a sudden resurgence of confidence. Until we address the structural problems in the economy, Keon said we won’t be able to get moving until we deal with the giant levels of debt. He says he’s currently holding allocations near benchmark weights, but is underweight TIPS bonds.

Top ETFs holding TIPS in alphabetical order:

  • Barclays Capital TIPS Bond Fund (TIPS)
  • PIMCO 1-5 Year U.S. TIPS Index Fund (STPZ)
  • SPDR Barclays Capital TIPS ETF (IPE)
  • SPDR DB International Government Inflation-Protected Bond ETF (WIP)

Notes from the Capital Link Conference

  • Morgan Stanley’s Dominic Maister, winner of the 2009 award for contribution to the ETF sector award and head of the Best ETF Research Team, moderated the ETF Roundtable. Maister says ETF assets grew 47% in 2009. Of that total asset growth, 50%, or $120 million, comes from net cash inflows. The other half from increased valuations. Equity ETFs see $30 billion in net inflows, while equity mutual funds see $9 billion in net outflow.
  • State Street Global Advisors’ director of ETF global capital markets, says the main driver of ETF growth the last few years was fixed income ETFs. From six fixed income ETFs in 2006 to 92 today. This has led to significant growth of full-service dealers using ETFs in portfolio models. Only 14% of institutional investors use ETFs, but they make up 50% of the assets. This would appear to mean there’s lot of growth potential left among institutions. Quigg said, “Institutions see ETFs as an investment tool, not a choice, and use ETFs to solve problems.” He said this usage will increase over the next 5 to 10 years.
  • Gabriel Hammond, the chairman and founder of Alerian, the index provider for the J.P. Morgan Alerian MLP Index ETN (AMJ). MLP stands for master limited partnerships, a company with a different tax structure than a public corporation. These often focus on the energy and oil sector. He says the big advantage ETFs have over closed-end funds is their liquidity and transparency. Probably most important, investors could pay up to 200 basis points more than an ETF to own the top ten holdings in the MLP space in an closed-end fund.

New ETF Tracks Long Term Corporate Market

State Street Global Advisors launched the SPDR Barclays Capital Long Term Credit Bond ETF (LWC) Wednesday on the NYSE Arca. It has an annual expense ratio of 0.15%.

The fund will track the Barclays Capital U.S. Long Credit Index. The index is comprised of dollar-denominated investment grade corporate and non-corporate credit bonds that have a remaining maturity of greater than or equal to 10 years. As of Dec. 31, 2008, the index held 965 issues with an average dollar-weighted maturity of 24.39 years.

“Demand for access to high quality, long term credit bonds is on the rise as investors search for alternatives to U.S. Treasuries that will improve the yield on their fixed income portfolios,” says Anthony Rochte, senior managing director at State Street Global Advisors in a written statement. “The SPDR Barclays Capital Long Term Credit Bond ETF is the longest-maturity credit bond ETF available to investors and a key addition to our growing family of fixed income SPDRs, which have attracted more than $800 million in net inflows in just the first two months of 2009.”

Currently, there are six long-term bond ETFs on the market. While those focus on Treasuries, the LWC follows corporate bonds, with the possibility of government bonds.

ETFs Transform Into Closed-End Funds

It appears some large, liquid ETFs are trading more like closed-end funds than ETFs. More to the point, the shares prices of bond ETFs are separating from their net asset values, which is the true value of the underlying assets.

“Almost anywhere you look, bond exchange-traded funds are trading at fire-sale prices,” says Murray Coleman in IndexUniverse. “In some cases, the distorations are shattering historic levels.”

Coleman is following up on a trend I noticed in the equity ETFs after the market’s Sept. 29 plunge. AT the time I saw equity ETFs were trading at a premium to their NAVs, and seeing larger tracking error than typically associated with the more liquid funds. IndexUniverse blames the disruption in the credit markets

How Did ETFs Fare in Market Turmoil

 

With cries of financial Armageddon and headlines screaming “heaven help us,” it shouldn’t have surprised anyone that the stock market took a head dive today.  The refusal of the House of Representatives to pass the $700 billion Wall Street bailout sent shivers through Wall Street. Everyone realizing the golden days are over made a mad dash for the exits.

 

“The first problem is the administration gave it the wrong name,” says Jerry Slusiewicz, president of Pacific Financial Planners of Newport Beach, Calif. “They should have called it the ‘economic stabilization plan’ or ‘liquidation enhancement plan,” instead they called it a ‘bailout’ and that was bad news. No one wants to bail out Wall Street.”

 

So, how did exchange-traded funds hold up amid the market turmoil?

 

“The ETFs followed the market,” says Kevin Mahn, chief investment officer of SmartGrowth Mutual Funds, which runs funds of ETFs. “The SPDR Gold Shares (GLD) was up as well as a lot of the short products from ProShares.” 

 

The truth of the matter is the ETF is only as good as the assets it’s holding. And if your ETF tracks the Dow Jones Industrial Average the day it plunges 777 points, like it did Monday in the largest one-day decline in history, you’re going to feel some pain, $6.40, or 5.76%, to be exact. Surprisingly, the Diamonds Trust, the ETF which holds every stock in the Dow, actually performed better than the index itself, which sank 6.98%. Who knew tracking error could work in your favor?

 

The same thing happened with the SPDR (SPY), the most heavily traded ETF on the market today, with 460 million shares trading hands. While its tracking index, the S&P 500 plummeted 8.79%, the SPDR tumbled just 7.84%, or $9.47.

 

The iShares S&P 500 Value Index Fund (IVE) beat the broader benchmark, and the growth sector, falling 6.76% to $57.85, on volume of 3.6 million shares, while the iShares S&P 500 Growth Index Fund (IVW) also beat it, sliding 7.1% to $54.66. And both closed at a premium to their net asset value, which was $56.34 for the value fund and $53.93 for growth, according to iShares.

 

And what of the fundamentally-focused ETFs which claim to do better than market-cap ETFs? How did they perform? PowerShares FTSE RAFI 1000 Portfolio (PRF) narrowly beat the S&P 500, with a decline of 7.46% to $44.02 on volume of 251,884 shares. The WisdomTree LargeCap Dividend Fund (DLN) slid 6.4% to $45.13 on 38,000 shares and the Spa MarketGrader LargeCap 100 (SZG) dropped just 5.34% to $17.55, with only 400 shares traded. All the fundamental ETFs also closed significantly higher than their NAVs.

 

“The House vote was basically a vote of no confidence for the credit markets,” says Slusiewicz. “Credit is drying up for short-term cash for the economy. We’ve backed ourselves into a corner.”

 

Overall the flight to quality led to an interesting divergence in the bond ETFs.

 

“The 0.4% move in the BIL was a hefty move,” says Jim Porter, the portfolio manager of Aston/New Century Absolute Return ETF Fund (ANENX).  “It broke out four days ago as there was definitely a sign of movement into the T-Bill ETFs. Meanwhile the Vanguard Intermediate Term Bond was actually down today. It’s obvious that no one wants to own the Intermediates. But the T-Bills and the long bonds are OK.”

 

n      The SPDR Lehman 1-3 Month T-Bill ETF (BIL) gained 20 cents, or 0.43%, to $46.24. This sent the yield down to 1.46% from 2.73% on Aug. 31.

 

n      The iShares Lehman 1-3 year Treasury Bond ETF (SHY) edged up 0.6% to $83.89, yielding 3.69%, up from 3.48% on Aug. 31.

 

n      The iShares Lehman 20+ year Treasury Bond ETF (TLT) climbed 2.9% to yield 4.68%, up from 4.53% on Aug. 31.

 

n      Meanwhile the Vanguard Intermediate Term Bond (BIV) fell 31 cents, or 0.42%, to 74.37. Since Aug. 31, when it yielded 4.63%, the BIV’s yield has plunged to a negative 1.64%.

 

So, what can we expect for the rest of the week? With the Jewish New Year occurring Tuesday and Wednesday, Congress won’t tackle any business until Thursday. In addition, with many market participants out, volume will probably be low, but that could create large price moves. The third quarter ends on Tuesday, so it should be an interesting day for mutual fund managers who need to shore up their portfolios for end-of-quarter reports.

 

“A lot of what we saw erased today will come back when the bill gets passed,” says SmartGrowth’s Mahn. “But there will be a lot of trepidation over the next few weeks to see if another bank fails and if this bailout works and how quickly it works.”   

 

Slusiewicz of Pacific Financial Planners thinks Congress will try to revive the deal because everyday that passes without one will see more market declines. He says the CBOE Volatility Index, or VIX, posting on Monday was “one of the top ten days for the fear index. The big fear number is an indication of a bottom. And the bottom will come with the passing of a new bailout bill.”

 

But, if there’s no bill Slusiewicz expects more days like Monday. With no bill, he predicts potential declines of 100 points on the S&P 500, 200 points on the NASDAQ and 700 points on the Dow.