As many of last year’s challenges to the US credit market linger and the growth tailwind fades, investors still face significant market noise. But as a new commentary from Invesco explains, one type of fixed-income ETF may help dampen the market noise and let investors pinpoint more attractive opportunities: defined-maturity bond funds.
“As expected, the Federal Reserve continued to push rates higher and shrink its balance sheet in 2018,” wrote Timothy Urbanowicz, CFA and senior fixed income ETF strategist. 1-year and 2-year Treasurys saw their rates rise by about 50% and 30%, respectively, while their 5- and 10-year counterparts saw a rise of around 13%. Meanwhile, 30-year Treasurys rose by about 10%.
“[T]his had a flattening effect on the yield curve, pushing the spread between 2-year and 10-year Treasuries to just 20 basis points to close the year — about 84% below the historical average,” Urbanowicz said.
Meanwhile, there was a steepening in the investment-grade credit curve amid falling non-US demand for corporate bonds, fears of a global growth slowdown rose, and heightened perceptions of credit risk. The longer end of the curve was somewhat tethered by strong US pension demand; a corporate buying spree by pension funds in the first half of 2018 resulted in inflows equivalent to four times those seen in all of 2017, based on data from the US Federal Reserve, Wells Fargo Credit Strategy, and Bloomberg.
The spread between investment-grade bonds and Treasuries saw their tightest level for this cycle in February 2018; the same happened for the spread between high-yield bonds and Treasurys in October. But the uptick in volatility in December caused both spreads to widen, pushing investment-grade spreads to 12% above their historical median going back to 2010 and high-yield spreads to 12% below their historical median levels.
“Despite the aforementioned concerns heading into 2019, end-of-2018 spread widening has potentially made both investment grade corporate and high yield corporate bonds more attractive for investors,” Urbanowicz said.
The softened Fed rhetoric around rate hikes and balance-sheet normalization earlier this month has eased some of the investor fear around rising rates. But because deteriorating economic conditions would be the likely cause for a rate-hike pause, Urbanowicz said, challenges may remain.
“With uncertainty around rates, credit spreads and growth, investors may be inclined to look to defined-maturity bond funds,” he said. While traditional fixed-income funds tend to sell bonds before their maturity date, defined-maturity funds seek to hold securities to maturity, at which time investors can either collect the proceeds from the maturing funds or reinvest the proceeds in a different ETF with a new maturity date.
Should rates go up and spreads widen, Urbanowicz said, investors have the choice to hold until final maturity. In case the opposite happens, they have exposure to credit markets and may be able to capture a potential rally in credit.
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