Financial advisors are embracing ultra-short bond funds to help clients eke out more yield in a rising interest rate environment plagued with multiple uncertainties.
Denton Olde, a CFP and head of financial planning firm Olde Wealth Management in Bellevue, Wash., moved into the ultra-short bond space in September after many of his clients experienced declines in the net asset values of their bond holdings during the first three quarters of 2018. With the Federal Reserve hiking the federal funds rate four times, “2018 was a difficult year for bonds in general,” he said. When interest rates rise, bond prices fall.
After harvesting some losses in his clients’ bond funds, Olde shifted some of their fixed income assets to the FlexShares Ready Access Variable Income Fund (RAVI), an actively managed ETF in the ultra-short category. According to Northern Trust Asset Management, which manages the Flexshares ETFs, RAVI is a cross between a money-market fund and an ultra-short fund because it seeks to keep duration at one year or less.
Olde also began investing in the FlexShares Core Select Bond Fund (BNDC), a tactical ETF (it has the ability to move around) with medium duration of 5.9 years. The fixed income portfolios of many of Olde’s 400 clients currently have a 25 percent allocation to RAVI and a 75 percent allocation to BNDC.
Before opting for shorter duration, Olde considered two other strategies to cope with a rising interest rate environment. One was bond laddering—buying bonds at different maturities and holding them. “It’s a viable strategy but it’s not super tactical,” he said. He briefly thought about using a floating interest rate fund but nixed this idea because bonds with lower credit quality could present concerns should a recession occur, he said.
According to Olde, shortening duration is a good way to address uncertainties this year about how many rate hikes the Fed may initiate, how the interest rate environment in general may change and how strong the economy may be. These uncertainties can impact not just the bond market but also the stock market, he said. By using the RAVI and BNDC funds together, he hopes that “if stocks zig, my bond portfolio will zag,” he said.
The ultra-short bond universe (ETFs and mutual funds) has exploded since 2008. According to Morningstar, the category had 74 open-end funds and 23 ETFs as of 2018. Four of the ETFs were launched last year, three in 2017 and three in 2016.
The ETFs in the ultra-short bond category “were less a post-GFC [global financial crisis] phenomenon and more a pre-money market reform one,” said Ben Johnson, director of global ETF and passive strategies research at Morningstar. “Most of the actively-managed ETFs in this category were launched as alternatives to money-market funds.”
Prior to the financial crisis and the subsequent reforms, money-market funds were a “one stop shop” for overnight liquidity, capital preservation and a decent return, said Mark Carlson, a senior investment strategist for FlexShares ETFs at Northern Trust Asset Management. The zero-interest-rate environment eliminated the ability to earn reasonable income from money-market funds, he said, and these funds are now restricted from moving out along the yield curve and stepping down credit quality.
RAVI is a liquidity management tool, said Carlson, who helped design the ETF and launch it in 2012. Its portfolio managers decide where to be along the yield curve based on Northern Trust’s interest-rate outlook. RAVI’s largest exposure is investment-grade corporate securities (89.6 percent). It has 7.1 percent in mortgage-backed/asset-backed securities and small allocations to government/agency, commercial paper and cash.