The problem with today’s bond market is basic bond math. As bond yields rise, bond prices fall. If, however, a bond’s coupon can cover the duration-induced price decline, then it’s not necessarily a loss-generating event from a total return perspective. But that is not the current case for traditional bond exposures like the Bloomberg Barclays US Aggregate Bond Index (the Agg).

Given more rate hikes are expected for the coming 12 months and record high duration of the Agg with yields below long-term averages, the drawdowns we have witnessed in 2018 bond markets are likely to continue. Because yields of shorter duration vehicles have risen along with broad bonds, there are more opportunities to generate income without taking on sizeable duration risks.

The best offense is a good defense

With rates rising and record high duration risk,1 we favor short duration corporate exposures and floating rates structures to lower interest rate sensitivity and deliver a more optimal yield and duration profile. This may lead to improved risk-adjusted performance and less drawdown than the broader fixed income market. Since the Federal Reserve began hiking rates more regularly in December 2016, floating rates exposures have had lower drawdowns among all the segments and a higher Sharpe ratio compared to the previous 10 years when rates were declining or flat.2

Investors interested in boosting yield without taking too much credit risk or duration induced downside risks may be better served by a 1-3 year corporate bond exposure than a 1-5 year corporate where the compensation for the 4-5 year corporate bucket provides little pickup in yield for the extended duration. An active short duration strategy may also be ideal to balance yield, duration and credit risks across many different bond sectors.

Target quality in credit

Solid but slowing economic growth may put the credit market under pressure when interest rates rise and nonfinancial corporate sectors become loaded with record levels of debt. For income-seeking investors who need a higher yield to satisfy income needs, moving up in quality in the credit space may be beneficial to position for a downhill credit climb. Senior to fixed rate high yield in the capital structure, senior loans have historically mitigated some of the downside risks in the credit market when spreads widened, while increasing income as rates rise.3

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Source: FactSet, as of 10/31/2018. Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment. It is not possible to invest directly in an index.

Implementation Ideas

Shorten duration and move up in quality to mitigate duration-induced price declines and credit risks.

  • SPDR® Bloomberg Barclays Investment Grade Floating Rate ETF (FLRN)
  • SPDR Portfolio Short Term Corporate Bond ETF (SPSB)
  • SPDR Bloomberg Barclays 1–3 Month T-Bill ETF (BIL)
  • SPDR DoubleLine® Short Duration Total Return Tactical ETF (STOT)
  • SPDR Blackstone / GSO Senior Loan ETF (SRLN)

Follow SPDR Blog to see our next strategic theme for tackling 2019, ‘Focus on Fiscal Policy Beneficiaries.’ You can also follow the whole 2019 Market Outlook series here.

1SPDR ETFs 2019 Market Outlook, https://us.spdrs.com/en/investment-ideas/market-outlook/get-defensive-in-bonds
2Yield spreads between the S&P/LSTA Leveraged Loan 100 Index and 3-month LIBOR are used as the credit spread of the loan index.
3FactSet, as of 10/31/2018.

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