The Federal Reserve’s September interest rate cut and expectations of more to follow are renewing interest in bonds. But some advisors and investors may be concerned about the impact lower rates have on the income in fixed income.
One way of contending with that scenario is to consider a barbell approach. That’s layering bonds of varying maturities to take advantage of duration opportunities while not taking on excessive amounts of interest rate risk. Exchange traded funds make that objective easier to implement. Two worth considering are the WisdomTree Yield Enhanced U.S. Aggregate Bond Fund (AGGY ) and the WisdomTree Floating Rate Treasury Fund (USFR ).
With AGGY, investors gain more yield than what’s found with traditional aggregate bond funds. USFR mitigates interest rate risk by holding floating rate notes. As WisdomTree’s Head of Fixed Income strategy Kevin Flanagan pointed out, USFR merits inclusion in the barbell. That’s because some short/ultra-short portions of the yield curve remain inverted. And that indicates there may be value available with short duration bonds.
How to Properly Portion AGGY, USFR
Earlier this year, Flanagan recommended a barbell comprising 70% allocation to USFR, with the remaining 30% directed to AGGY. Following the aforementioned Fed rate cut, he’s altered that to 60% USFR/40% AGGY.
“This updated allocation provides a yield-to-worst of 4.68% while bringing duration to just a little above 2½ years (2.62). To sum up, this hypothetical barbell potentially offers a yield advantage of 51 bps versus the benchmark Agg, but with only a little more than one-third of the duration risk,” he wrote in a recent report.
The rate cut isn’t the only reason behind the altered USFR/AGGY barbell. Flanagan mentioned important factors behind that change. They include the U.S. economic outlook, 10-year Treasurys already having baked in a lot of good news, and the lingering inversion of the three-month/10-year yield curve.
Fixed Income Investment Landscape Like 'Fluid' Ahead
Ultimately, a bond barbell could be useful to fixed income investors. That’s because, as is always the case in financial markets, there’s no certainty about what comes next. For example, economic data could surprise to the downside and the presidential election could stoke volatility.
“The investment landscape for fixed income promises to be a fluid one in the months ahead, especially as Fed rate cuts play out,” concluded Flanagan. “Thus, the barbell allocation shifts presented here are not meant to be static in nature, but more of a dynamic process. By toggling the weights on either end of the barbell, this strategy offers a user-friendly solution for investors to adapt their bond portfolios to potential changes that may be needed.”
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