Rising Rates Implementation Plan: “Core Plus” & Risk Management by Rick Harper, Head of Fixed Income & Currency and Bradley Krom, The WisdomTree Blog

Over the last several weeks, we have spent a great deal of time discussing what might be next for U.S. fixed income markets. While our view on rising rates has yet to meaningfully materialize this year, our underlying thesis has not changed. In our view, it may be time for investors to think about how a bond portfolio may perform as a result of changes in Federal Reserve (Fed) policy. From our discussions, we understand that some advisors believe that they already “made their trade” for rising rates last year. In our view, a great deal has changed since that time. As a result, we believe that investors should reexamine their current positioning and consider additional options to help manage interest rate risk.

In recent years, many investors have extended beyond investment-grade fixed income to incorporate satellite positions in high-yield corporate bonds. Money managers have employed these so-called “core plus” strategies as a way to potentially add value to investors’ portfolios. Ultimately, these strategies seek to balance income and credit risk in order to increase total returns.

When devising new alternatives, WisdomTree’s approach to rising rates has sought to avoid forcing advisors to fundamentally alter the way they run portfolios. Our goal was to maintain the exposures investors were familiar with while managing the risks. We believe that exchange-traded funds (ETFs) can provide a powerful tool for investors seeking to manage their exposure to credit. Through our suite of rising rate strategies, we believe that investors can mitigate interest rate risk in the same way.

While some investors may use our rising rate suite piecemeal, in our opinion, the real strength of the strategies is how they can be combined as part of an existing portfolio. By constructing portfolios using zero duration and negative duration tools, as shown in the tables, advisors can further refine their specific exposure not only to credit risk but also to a specific level of interest rate risk.

Impact of Incorporating Rising Rate Strategies in “Core Plus” Portfolios

Rising Rates Core Plus Risk Management

For definitions of indexes in the chart please visit our glossary.

The left-hand table shows a variety of hypothetical zero duration core plus blends. Compared to a traditional approach, investors are able to reduce their portfolio duration to zero at a cost of 1.37% per year. While this portfolio sacrifices approximately 44% of its income potential, interest rates would only need to rise by approximately 27 basis points (bp) over the course of a year to break even. If investors believe that rates could rise by more than this amount, hedging could potentially add value.

Turning our attention to the table on the right, we see that investors can have a greater impact on the duration of their portfolio when they blend exposure with a negative duration core plus strategy. However, this approach may be more sensitive to distortions in the shape of the yield curve. Since this strategy is constructed through selling longer-duration securities, a rise in interest rates might be possible, and investors’ hedges may not immunize their portfolio from losses resulting from these higher interest rates. However, for investors with a stronger conviction about rising long-term interest rates, a negative core plus strategy can provide positive income potential with a negative duration position of more than five and a half years. This approach could allow investors to essentially finance their negative interest rate bet, compared with the negative carry associated with shorting bonds outright.

Ultimately, investing is largely about tradeoffs. As we highlighted earlier, we believe that our suite of rising rate strategies can provide powerful tools for investors seeking to manage risk in their portfolio. By striking the appropriate balance between credit and interest rate risk, we believe that these approaches may help add value to investor portfolios as the Fed begins to normalize its monetary policy.

Important Risks Related to this Article

There are risks associated with investing, including possible loss of principal. Non-investment-grade debt securities (also known as high-yield or “junk” bonds) have lower credit ratings and involve a greater risk to principal. Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. The duration Funds seek to mitigate interest rate risk by taking short positions in U.S. Treasuries, but there is no guarantee this will be achieved. Derivative investments can be volatile, and these investments may be less liquid than other securities and more sensitive to the effects of varied economic conditions.

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. The duration Funds may engage in “short sale” transactions of U.S. Treasuries, where losses may be exaggerated, potentially losing more money than the actual cost of the investment, and the third party to the short sale may fail to honor its contract terms, causing a loss to the duration Funds. While the duration Funds attempt to limit credit and counterparty exposure, the value of an investment in the duration Funds may change quickly and without warning in response to issuer or counterparty defaults and changes in the credit ratings of each Fund’s portfolio investments.

Investors should anticipate that due to the negative duration target, those Funds will be highly sensitive to interest rate changes. The higher (whether positive or negative) a bond fund’s duration, the greater its sensitivity to interest rates changes, and fluctuations in value, whether positive or negative, will be more pronounced. 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. Due to the investment strategy of certain funds, they may make higher capital gain distributions than other ETFs.

Securities with floating rates can be less sensitive to interest rate changes than securities with fixed interest rates, but they may decline in value. The issuance of floating rate notes by the U.S. Treasury is new, and the 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. Please read each Fund’s prospectus for specific details regarding each Fund’s risk profile.