By Kevin Flanagan, Senior Fixed Income Strategist
Just when the focus was shifting to robust U.S. growth numbers and higher inflation readings, global events, once again, interjected themselves into the bond market equation. This time around the headlines centered on developments in Turkey and what potential ramifications they could have on the broader investment landscape. Specifically, as it relates to fixed income, should investors revisit their views on U.S. rates and, by extension, their portfolio positioning?
While Turkey may have been the catalyst for the most recent flight-to-quality trade, financial market reactions were a reminder that the global backdrop for investors has been shifting. Indeed, tariffs and concerns over trade wars have certainly entered the mix, as have elevated anxieties about emerging markets (EM) in general. Besides Turkey, countries such as Argentina, South Africa and even Russia have been making their way into the collective investor mindset, and doubts are creeping in regarding growth prospects for China.
Perhaps the most important aspect of change has been the shift in financial conditions. To be sure, the global central bank backdrop is no longer a "pedal to the metal" policy, but in the developed world, the approach has been on beginning the process of normalization. Without a doubt, the Federal Reserve (Fed) has been the leader on this front, but other central banks in the developed world have begun jumping in as well. The Bank of Canada and the Bank of England have both raised rates this year, while the European Central Bank is expected to continue paring down its quantitative easing program and ultimately ending new asset purchases by year-end.
Another important factor is the specter of continued U.S. Treasury (UST) supply increases. With U.S. budget deficits on an ascending trajectory, investors will be faced with an environment of more Treasury securities coming to market at a time when the Fed is reducing its reinvestments, and global investors in general may be commanding some concessions at future auctions.
So, what's a fixed income investor to do? WisdomTree offers three fixed income solutions for the landscapes laid out here.
- First, if you fall into the camp that believes "Turkey contagion" and trade wars will be the primary forces looming, then odds would favor that UST yields have already peaked and may be set for a more sustained move to lower readings. Against this backdrop, investors should consider the WisdomTree Yield Enhanced U.S. Aggregate Bond Fund (NYSEARCA:AGGY).
- The other view would be that recent increases in trade tariffs and EM turmoil will not serve as meaningful impediments to the domestic growth and inflation outlooks. In this case, the Fed would continue on its policy normalization path and maintain its gradual path of future rate increases. This scenario would highlight the need for further rate-hedging solutions, with investors considering the WisdomTree Floating Rate Treasury Fund (NYSEARCA:USFR) for their portfolios.
- On a final note, perhaps the most opportune approach would be to implement the barbell strategy I discussed in last week's blog post, "The Barbell Approach: A Time-Tested Fixed Income Strategy." This strategy offers investors a solution that takes both sides of the rate trade into consideration.
Important Risks Related to this Article
There are risks associated with investing, including possible loss of principal. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty; these risks may be enhanced in emerging or frontier markets. Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline. Investing in mortgage- and asset-backed securities involves interest rate, credit, valuation, extension and liquidity risks and the risk that payments on the underlying assets are delayed, prepaid, subordinated or defaulted on. Securities with floating rates can be less sensitive to interest rate changes than securities with fixed interest rates, but may decline in value. The issuance of floating rate notes by the U.S. Treasury is new and the amount of supply will be limited. Fixed income securities will normally decline in value as interest rates rise. The value of an investment in the Fund may change quickly and without warning in response to issuer or counterparty defaults and changes in the credit ratings of the Fund's portfolio investments. Due to the investment strategy of these Funds, they may make higher capital gain distributions than other ETFs. Please read each Fund's prospectus for specific details regarding the Fund's risk profile.
Kevin Flanagan, Senior Fixed Income Strategist
As part of WisdomTree's Investment Strategy group, Kevin serves as Senior Fixed Income Strategist. In this role, he contributes to the asset allocation team, writes fixed income-related content and travels with the sales team, conducting client-facing meetings and providing expertise on WisdomTree's existing and future bond ETFs. In addition, Kevin works closely with the fixed income team. Prior to joining WisdomTree, Kevin spent 30 years at Morgan Stanley, where he was most recently a Managing Director.
He was responsible for tactical and strategic recommendations and created asset allocation models for fixed income securities. He was a contributor to the Morgan Stanley Wealth Management Global Investment Committee, primary author of Morgan Stanley Wealth Management's monthly and weekly fixed income publications, and collaborated with the firm's Research and Consulting Group Divisions to build ETF and fund manager asset allocation models. Kevin has an MBA from Pace University's Lubin Graduate School of Business, and a B.S. in Finance from Fairfield University.