Hablas Bonos? Translating Views Into Fixed Income

by: Matt Tucker, CFA

I’ve been thinking a lot lately about translations. Not languages, though. Ideas.

People who implement market views with stocks have historically hesitated to implement their views via bonds.

Why? Because it’s hard to build bond portfolios by hand, one bond at a time. In the old days, if an investor had a view on corporate bonds, they’d have to research, price and source the bond themselves (potentially hundreds of times over, in order to achieve diversification). And if, for example, the investor wanted to shift out of corporate bonds and into another market, they’d have to research and build the new portfolio, not to mention go through the hassle and cost of liquidating the original portfolio of corporate bonds.

Creating and managing a portfolio of hundreds of bonds is not easy. It doesn’t serve as great fodder for interesting dinner conversation, either. As a result, many investors turned to active mutual fund managers to outsource their fixed income exposure. Rather than having a view themselves, they relied on the manager to have a view for them.

However, with the advent of fixed income ETFs, investors are starting to build fixed income portfolios on their own. Fixed income ETFs offer many of the same benefits as mutual funds (like diversification), with added transparency and liquid access.

In addition, investors are discovering that they do have a view on fixed income, enough so that they don’t wish to outsource it to someone else. Because the thing is, if you have a view on the market, then you have a view on fixed income. I’ll explain.

Let’s say you believe that the economy is starting to recover. As applied to equities, an investor might buy high beta stocks, consumer cyclicals or growth stocks. In fixed income, that same view means buying high yield corporates, investment grade corporates, or commercial mortgage backed securities. Same idea, just applied in a different asset class.

Here are a few more examples:

Click to enlarge

(The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective.)

The bottom line? Regardless of your market views, you now have the ability to implement them in both equities and fixed income. No translation necessary.

Diversification may not protect against market risk. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.

Bonds and bond funds will decrease in value as interest rates rise. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity. Mortgage-backed securities (“MBS”) represent interests in “pools” of mortgages and are subject to credit, prepayment and extension risk, and therefore react differently to changes in interest rates than other bonds. Small movements in interest rates may quickly and significantly reduce the value of certain MBS. An investment in the Fund(s) is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.

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