3 year-end bond moves to consider

In her first article for the blog, Heather Brownlie talks about how investors can build a bond portfolio on the back of rising yields.

I still have a land line phone. I never use it, no one I know calls me on it, but every month I pay the bill, almost without thinking about it. Staying tethered to the service is simply a habit (one I’m determined to break as part of my year-end checklist.)

A similar thing has been happening in the bond market. In the decade since the financial crisis, “lower for longer” has been the mantra for interest rates. Ten years is a long time, and in the interim many bond investors have acquired the “muscle memory” of stretching for yield to meet their income goals. Now that the Fed is gradually raising its policy rate, however, it may be time for investors to break the habit of outsized credit and liquidity risks, and learn a new routine.

The low rate environment had a big impact on how portfolios were constructed over the last decade. Not only have intermediate bond managers tilted into high-yield, emerging markets and loans but many investors also have strayed out of bonds altogether, into dividend-paying stocks. As we can see in the chart, since 2008 the median intermediate-term bond fund (orange line) has become increasingly correlated to the stock market. Correlations dropped sharply in 2014, but have been inching up again.

bond correlationFinal

Why is this a problem? The reach for yield reduces the potential diversification benefits of owning bonds by increasing correlations to stocks. In other words, many of us likely have strayed from a primary purpose of owning bonds: offsetting the risk of stock volatility, something we’ve had no shortage of lately.

icon-pointer.svgLearn how the pros use bond ETFs.

The good news is that we now have an opportunity to course-correct. And now, as you do a bit of year-end financial housekeeping, is a good time to revisit how you are sourcing yield and at what price.

Here are three simple things to consider:

(1) Consider short maturity bonds.

With a flat yield curve and relatively tight credit spreads today, you don’t need to take on much interest rate risk or rely on higher-risk assets like stocks to generate income potential. High-quality ultrashort- and short-duration bonds are sitting in a sweet spot right now: they offer potentially attractive yields, and their short duration means they’re less exposed to interest rate risk (duration).

(2) Rotate up in credit quality.

We haven’t yet seen a material uptick in bond market volatility. As and when that may happen, though, we tend to see credit risk increase with it. Consider that the two-year Treasury currently yields nearly 3%, according to Bloomberg. Rotating into an ETF like the iShares 1-3 Year Treasury Bond ETF (SHY) can be a low-cost way to up the overall credit profile of your portfolio. You might even be able to capture a tax loss, as market prices for investment-grade corporate bonds have declined somewhat. Another option to consider is the iShares Short Maturity Bond ETF (NEAR), with a mix of floating and fixed rate bonds  and more than 65% in issuers rated at least single A.[1]

(3) Keep more of what you earn.

Could you be paying over 20% of your yield in fees? Shocking, right? I had the unpleasant experience of seeing that the seven-day cash yield in my brokerage account was in a government fund charging 42 basis points in annual fees, or nearly 20% of its gross yield. In a similar vein, I recently heard a pitch for a four-star short duration fund charging nearly 70 basis points. It may have sounded like a compelling story, but not at 25% of my yield. This should go without saying, but over time price can materially impact performance.

It’s a new era for interest rates and time for a rethink on building a portfolio for the outcomes you want. As “lower for longer” becomes yesterday’s truth, it’s time to cut the cord on old habits and develop new ones for your bonds.

Heather Brownlie is the U.S. head of BlackRock’s Fixed Income iShares

[1] : Credit quality ratings on underlying securities of the fund are received from S&P, Moody’s and Fitch and converted to the equivalent S&P major rating category. This breakdown is provided by BlackRock and takes the median rating of the three agencies when all three agencies rate a security the lower of the two ratings if only two agencies rate a security and one rating if that is all that is provided. Unrated securities do not necessarily indicate low quality. Below investment-grade is represented by a rating of BB and below. Ratings and portfolio credit quality may change over time. Allocations are subject to change.

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

The iShares Short Maturity Bond ETF (NEAR) is actively managed and does not seek to replicate the performance of a specified index. The Fund may have a higher portfolio turnover than funds that seek to replicate the performance of an index.

NEAR will invest in privately issued securities that have not been registered under the Securities Act of 1933 and as a result are subject to legal restrictions on resale. Privately issued securities are not traded on established markets and may be illiquid, difficult to value and subject to wide fluctuations in value. Delay or difficulty in selling such securities may result in a loss to the iShares Short Maturity Bond ETF. The fund may invest in asset-backed (“ABS”) and mortgage-backed securities (“MBS”) which are subject to credit, prepayment and extension risk, and react differently to changes in interest rates than other bonds. Small movements in interest rates may quickly reduce the value of certain ABS and MBS.

An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency and its return and yield will fluctuate with market conditions.

Diversification and asset allocation may not protect against market risk or loss of principal.

Transactions in shares of ETFs will result in brokerage commissions and will generate tax consequences. All regulated investment companies are obliged to distribute portfolio gains to shareholders. Diversification and asset allocation may not protect against market risk or loss of principal.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective. This material does not constitute any specific legal, tax or accounting advice. Please consult with qualified professionals for this type of advice.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

This post contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

The iShares Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).

©2018 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

ICRMH1218U-688324-1/1