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Summary

  • There is divergence in U.S. fundamental and technical data, which suggests that investors should not chase the markets.
  • Investors should create parameters and work inside them, thinking inside a box.
  • Through this technique, investors can create a portfolio which meet their terms and conditions, a box paradigm.

"Train yourself to let go of the things you fear to lose" - George Lucas

The cynicism still remains. U.S. equity markets are at all-time highs, the Fed is unwinding the extraordinary accommodative measures, yet U.S. yields are declining. As mentioned in my previous article, investors should not focus on chasing shadows, but devise and maintain strategies that work for them. One such strategy, the box paradigm, takes on duration risk for a higher distribution yield than the benchmark (NYSEARCA:AGG). The ETF portfolio selected to meet these objectives is seen below. Also the total return of the securities from when it was originally recommended (September 2013) should be noted.

Table 1 Box Paradigm U.S. Fixed Income ETF Portfolio

Ticker

Long Name

% of Portfolio Size

Market Cap. (U.S.$)

Average Life

Modified Duration

Annual Distribution Yield

Current Yield

YTD Return

Total Return since original Box Paradigm Article

(NYSEARCA:FLOT)

iShares Floating Rate Bond ETF

20%

3.47Bn

2.12

0.15

0.47%

0.52%

0.08%

0.55%

(NYSEARCA:BSV)

Vanguard Short-Term Bond ETF

20%

35.7Bn

2.8

2.7

1.38%

1.00%

0.36%

1.43%

(NYSEARCA:BIV)

Vanguard Intermediate-Term Bond Index ETF

15%

14.7Bn

7.3

6.5

3.73%

2.70%

3.23%

5.59%

(NASDAQ:VCIT)

Vanguard Intermediate-Term Corporate Bond Index ETF

20%

4.1Bn

7.5

6.5

3.83%

3.30%

4.04%

7.64%

(NYSEARCA:BLV)

Vanguard Long-Term Bond ETF

10%

6.5Bn

24.1

14.3

4.26%

4.20%

8.90%

11.39%

(NASDAQ:VCLT)

Vanguard Long-Term Corporate Bond Index ETF

10%

1Bn

24.1

13.6

4.45%

4.70%

7.58%

12.90%

AGG

iShares Core Total U.S. Bond Market ETF

5%

17.43Bn

6.87

5.2

2.31%

2.05%

2.33%

4.47%

Environment Outside the Box

The environment should be first ascertained, so that a proper box can be constructed. Over the 1st quarter of 2014, U.S. GDP fell 1% quarter-over-quarter, and it only grew 2% year-over-year. U.S. GDP is currently below the 4-quarter moving average of 2.1%. The below-average pace was as a result of worse-than-expected weather conditions, which made companies add to inventories at a slower pace and also curtailed investments. The chart below shows U.S. GDP.

Chart 1 U.S. GDP Y-o-Y Mar-04 to Mar-14

(click to enlarge)

On the other hand, U.S. CPI rose in April 2014 by the most in almost a year, indicating that U.S. inflation may remain above the 2% threshold for 2014. The chart below shows U.S. CPI.

Chart 2 U.S. CPI Y-o-Y Apr-04 to Apr-14

(click to enlarge)

When the volatile food and fuel parameters are excluded, the core CPI rose 1.8% year-over-year for April 2014. The rise in inflation was driven by increases in rent prices and food costs.

Non-farm payrolls increased by 217,000, but the unemployment rate remained firm at 6.3%. While labor force participation remained low at 62.8%, average hourly earnings rose 2.1% year-over-year. With this economic painting set, the Fed continues with its observations and makes its conclusions. The Fed maintained its reduction in asset purchases or QE. Also, with inflation being back on the front burner, expectations are for the Fed to raise rates by mid-2015.

Despite the data provided, yields remain low. The U.S. 10-year yield made a high of 3.05% on January 2nd 2014, and subsequently declined over the next 6 months, making a low of 2.40% on May 29th 2014. The longer-termed U.S. 30-year yield also declined from a high of 3.97% on January 2nd 2014 to a low of 3.26% on May 29th 2014. The charts below show the U.S. 10-year and 30-year yields.

Chart 3 U.S. 10-Year Yield

(click to enlarge)

Chart 4 U.S. 30-Year Yield

(click to enlarge)

Assumptions and Box Metrics Still Hold

The cynicism still prevails. While the fundamental data and policy point to a rise in yields, the technical data show a decline. With this data duplicity, investors should assume the worst-case scenarios which prevent ruin but leave room for gains, a personal put option. Thus, the paradigm metrics hold support. Please see below the box metrics of the U.S. Fixed Income ETF Portfolio.

Table 2 Box Metrics of U.S. Fixed Income ETF Portfolio

Fundamental/Technical Event/Trigger

Assumptions/Reasoning

ETF Reference

25% Stop Loss

A 25% move lower on a security represents a significant bear move. Thus, conditions have changed.

All ETFs in the portfolio.

Portfolio Benchmark is AGG.

AGG represents an investor with USD with 5-7 years until retirement, and is increasing his portfolio to fixed income from equities. The focus would be income generation and principal preservation.

AGG

UST 10-Year and 30-Year will not trade over 3% and 4% respectively. If this occurs and lasts for more than 1 month, exit ETFs with an average life greater than 10 years and utilize proceeds to enter floating rate ETFs, as well as ETFs with tenor 0-5 years.

The view exists that the Fed will not raise rates until June 2015. Technically, the UST 10-Year and 30-Year yields also appear to be trending lower.

BLV, VCLT, FLOT, BSV

Weighted Average Annual Distribution Yield should be greater than US CPI percentage change year-over-year.

The fixed income ETF portfolio should be created to beat inflation and the benchmark's trailing 12-month distribution yield.

All ETFs in portfolio

ETFs should have an investment grade credit rating or rating equivalent.

The portfolio should meet the risk profile of the investor.

All ETFs in portfolio

The box paradigm portfolio weightings hold until the triggers are achieved, that is, a recognizable change in the interest rate environment in the U.S. Furthermore, box construction prevents chasing the market and ensures that the objectives are set and met.

Source: Box Paradigm Redux - A U.S. Fixed Income ETF Portfolio