The past few months have seen a significant shift in perceptions regarding monetary policy settings. Primarily courtesy of rising inflation, but also on a more widespread acceptance that, despite some contrarian signals in the case of the UK and an obvious core-periphery divide in the case of the Eurozone, the overall economic landscape has improved. Measures of market expectations on monetary policy have moved from the “accommodative” to the “gradual tightening”. The European Central Bank (ECB) made good on its early March warning and raised interest rates by 25 basis points to 1.25% at the April rate-setting meeting, while leaving the door open for further moves as the year progresses. Meanwhile, the Bank of England (BoE) is keeping a steady hand, although most market analysts agree that the process of normalisation (e.g. tightening) could be kick-started later in the year, particularly so if the 4Q 2010 GDP drop is confirmed as a blip in the otherwise upside trend.
Moves on interest rates, whether delivered or priced in, have a direct impact on the value of fixed income securities. Bond prices are inversely correlated with the direction of interest rates, which means that fixed income holdings are to lose value as the screws of monetary policy are tightened up. Of course, price alone is but a factor determining the overall value of a fixed income security, the other being yield; and yields move in tandem with interest rates. Capital losses thus have to be weighed up against the potential benefits of increased yields across the maturity spectrum. But let’s not overcomplicate things and instead focus on the pressing issue of how investors can insulate their fixed income portfolios from principal losses.
As part of our ever-growing coverage of the European ETF market, we have already written a number of pieces dealing with this very issue. The article Managing Interest Rate Risk with ETFs is a basic tutorial explaining the key concept of duration and how the ETF industry has been rising to the challenge of providing a suite of instruments to allow investors an optimal management of interest rate exposure. Meanwhile, the more recent article Slow Or Fast, UK Interest Rates Are Only Going Up, delved into the implications of monetary policy changes for a UK-centric fixed income portfolio.
The common thread for both articles was the focus on a single asset class within fixed income, namely government bonds. But despite the noted rise in yields, and despite ongoing sovereign concerns in the Eurozone, government bonds remain amongst the least rewarding vehicles within the fixed income universe. And so, the challenge for some fixed income investors will be not just how to shorten duration, but how to do so while increasing yield potential at the same time. This calls for investors to spread out of the government bond ETF class into higher-yielding fixed income ETF alternatives. By doing so, investors will be taking on additional notional risk and in some cases also foreign exchange risk.
The following is a selection of European-domiciled fixed income ETFs that can help investors achieve the dual goal of shortening duration while enhancing yield. Their metrics, taken as of mid-April, are benchmarked against the iBoxx EUR Sovereign Eurozone AAA TR index (yield to maturity 2.97%; duration 6.3 years) and the FTSE UK Gilts All Stock index (yield to maturity 3.02%; duration 8.6 years). (Note - For the benefits of more accurate comparison, the chosen indices only encompass AAA-rated government bonds)
See Our Selection of Five ETFs to Shorten Duration While Enhancing Yield
