If recent ETF trends are any indication, investors are getting jittery about the prospect of rising interest rates. Since the beginning of the year, short-term and floating-rate funds have seen a gush of investor money while longer-term bond funds, which suffer greater price erosion in a rising-rate environment, have been leaking assets.

This “duration rotation” has come amid an early-year uptick in interest rates. In the first quarter of the year, the Barclays Capital Aggregate Bond Index lost 0.13%, marking the first quarter of negative returns for the broad bond benchmark since 2006. Forecasts are also shifting; Goldman Sachs recently raised its forecast figures for Treasury yields at the end of 2013 from 2.2% to 2.5% and at the end of 2014 from 2.75% to 3.0%.

This isn’t the first time that the year has begun with interest rate creep. In every year since 2009, in fact, rates on 10-year Treasury bonds inched up between January and March but fell back as the year progressed.

Given the length of the low interest rate era, it’s no surprise that some ETF investment managers aren’t sounding any alarm bells this time around. “If you asked me two years ago whether or not I thought interest rates would increase, I would have said yes,” says Brendan Clark, president of Clark Capital Management in Philadelphia. “If you asked me last year, I would have said the same thing. But the Fed has been so effective in keeping rates artificially low that at this point I’m inclined to believe rates will be staying low for a while.”

“The number one question we got from investors in 2010 was how we were going to handle the possibility of rising rates,” says Rob Williams, director of research at Sage Advisory Services in Austin, Texas. “We told them we still have a ways to go before that happens. We still think that’s true.”

Nonetheless, the uncertain climate leaves ETF investment managers with the puzzle of how to construct portfolios that both hit income targets and provide downside protection in case the most recent early-year interest rate uptick is more than a fluke. With yields so low for so long, investors have picked through just about every corner of the fixed-income markets, making it extraordinarily difficult to find reasonably priced investments.

“Nothing in the income space is undervalued at this point,” says Steven MacNamara, president of Horizons West Capital Partners in Newtown, Conn. “So the risk of being wrong is higher than it’s been for quite a while.”

To help lower that risk, MacNamara and others are mixing things up with fixed-income ETFs that cover a variety of sectors, geographic areas and maturities and combining them with other high-income asset classes such as preferred stock.

The combination of ETFs for Horizons West’s most conservative portfolio geared for retirees produces a yield of about 3.5%. The iShares Barclays Intermediate Credit Bond Fund (CIU), which focuses on investment-grade corporate U.S. debt as well as dollar-denominated non-U.S. bonds, serves as a core holding. With an effective duration of 4.3 years and a distribution yield of 2.76%, the fund generates a decent level of income without going too far out on the yield curve or taking on too much credit risk. 

Shorter-term bond holdings include the iShares Barclays 0-5 Year TIPS Bond Fund (STIP), which offers inflation protection and higher yields than cash investments. With an effective duration of just under two years and a distribution yield of 4.9%, the PIMCO 0-5 Year High Yield Corporate Bond Index Exchange-Traded Fund (HYS) provides an alternative to longer-term high-yield funds.

In addition to straight bond ETFs, Horizons West’s portfolio also holds high-yielding hybrid securities through ETFs such as the iShares S&P U.S. Preferred Stock Index Fund (PFF) and the SPDR Barclays Convertible Securities ETF (CWB). The ETFs provide attractive income and potential for appreciation, and they are less sensitive to interest-rate risk than traditional bonds.

Less than 3% of the firm’s conservative portfolios are in high-yield stock ETFs, a hot area of the market that MacNamara thinks is too risky for most retirees. “You have to remember that some high-yield stock ETFs lost half their value in 2008,” he says. “For investors who depend on their portfolios for income, it’s not a responsible trade.”

Despite his sanguine outlook for interest rates, Brendan Clark hasn’t turned a blind eye to the risks of even a small rise in rates. “Interest rates are so low that a return to normal interest rate levels for longer-term Treasury bonds would have a devastating impact on bond prices,” he says. “So at this point, we prefer to take credit risk rather than duration risk.”

With that in mind, his firm is allocating a substantial portion of fixed-income assets to high-yield exchange-traded funds, including the iShares iBoxx $ High Yield Corporate Bond Fund (HYG), the SPDR Barclays High Yield Bond ETF (JNK) and the SPDR Barclays Short Term High Yield Bond ETF (SJNK). He says a combined duration of 3.6 years for these funds isn’t all that risky in today’s steady rate environment. And junk bonds are less interest-rate sensitive than Treasury bonds or investment-grade corporate debt.

Last year, the flurry of investors moving into ETFs that follow below-investment-grade securities drove yields lower, and Clark acknowledges that they’ve become “a crowded trade.” Still, he says, high yield remains one of the better values in the bond market.

“Treasurys are much more overvalued than high-yield debt,” he says. “The current default rate for high-yield bonds is less than 2%, compared to a historic average of around 5%. And corporate balance sheets are in their best shape in 50 years.” Some of the firm’s conservative portfolios also have a sprinkling of emerging market bond exposure through the iShares J.P. Morgan USD Emerging Markets Bond Fund (EMB), which acts as a good diversifier and a complement to domestic high-yield debt.

At Sage, the core fixed-income portfolio has an effective duration of about 4.5 years, a bit below that of the Barclays Capital Aggregate Bond Index. Investment-grade bond ETFs such as the iShares Barclays 7-10 Year Treasury Bond Fund (IEF), the iShares Barclays MBS Bond Fund (MBB) and the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD), account for about 80% of the firm’s most conservative income portfolios.

Another 10% is allocated to preferred stock through the iShares S&P U.S. Preferred Stock Index Fund (PFF). Williams believes the improving balance sheets of some issuers, particularly banks, give investors a good shot at appreciation. He adds emerging market exposure for another 10% of the portfolio through the WisdomTree Emerging Markets Local Debt Fund (ELD). Because the ETF owns local currency bonds, it stands to benefit from a strengthening of emerging market currencies against the U.S. dollar as well as growth in those economies.

Unlike Clark, Williams isn’t enthusiastic about the corporate high-yield bond sector because yields aren’t as attractive as they used to be, and he sees issuer-specific risk as a growing problem. “Shareholder demands such as forcing leveraged buyouts could have a negative impact on some companies’ equities and junk bonds,” he says. “There are more attractive areas of the credit market.”

High Yield “Light”
  Senior bank loan etfs are emerging as one of the fastest-growing breeds of income generators. The most popular of these ETFs, the PowerShares Senior Loan Portfolio (BKLN), raked in $1.5 billion in the first three months of 2013 alone. Other offerings in this genre, such as the Highland/iBoxx Senior Loan ETF (SNLN) and the SPDR Blackstone/GSO Senior Loan ETF (SRLN), have also seen tremendous growth.
   These ETFs track senior secured bank loans—variable-rate loans that are made by banks to non-investment-grade companies and secured by real estate or some other asset. The rate on the loans changes every 30 to 90 days and is usually pegged to the London Interbank Offered Rate (LIBOR).
   Investors are attracted to these ETFs for a number of reasons, including recent yields of around 4%. When the rates on the portfolio loans rise, the ETF yields follow suit, which makes them especially attractive in a rising-rate environment. With a minimal correlation to fixed-rate bonds, senior secured bank loans also provide diversification for income portfolios.
   Because these loans are senior to bonds and stocks in a company’s capital structure, investors go to the head of the payback line if a borrower hits tough times. Some investors have dubbed the loans “high yield light,” since the combination of floating rates, loan collateral and position in the corporate capital structure makes senior secured bank loans less risky than traditional high-yield bonds.
   Although the ETFs are fairly new, institutional investors and mutual funds have been investing in senior secured bank loans for over 20 years. In a report issued in April, Morningstar, which has been tracking the bank loan sector since 1989, noted that the group typically shows positive performance even during recessions. The major exception occurred during the financial crisis of 2008, when issuers defaulted and bank loans plunged 29%.
   While there could always be another recession, there’s no reason to panic or avoid bank loan investments, says Morningstar ETF analyst Timothy Strauts. He attributes 2008’s massive losses to the loan boom in 2006 and 2007, when many companies used them to finance leveraged buyouts.
   He believes today’s senior bank loans have a more conservative risk profile than those loans issued during those boom years. “The highly leveraged hedge fund investors who drove much of the market volatility have not returned in large numbers,” he says. “While a recession would hurt returns, the bank-loan market appears better prepared for a downturn today than it was in 2008.”