What is the Total U.S. Bond Market?
You often hear people on TV talk about the bond market in broad, general terms. But there’s many different fixed income categories including Treasuries, Corporates, Municipalities, Mortgage and Asset Backed Securities and Sovereign debt. Each category has different characteristics such as tax implications, risk profiles and yield expectations. With so many investors having different types of bonds in a portfolio, a total U.S. bond market inverse ETF can hedge broad fixed income exposure.
The Barclay’s U.S. Aggregate Bond Index is designed as a total U.S. bond index. The index is a good sampling of the taxable U.S. bond market, comprised of roughly 38% U.S. Treasury bonds, 29% Mortgage-Backed Securities, 25% investment grade corporates and 7% Federal agency issued bonds, and offers investors a way to invest in securities that track the index. It’s a cost-effective way for investors to gain diversified access to broad fixed income exposure and many total return bond funds that you may have in a retirement account are comprised of various different bond classes.
What’s the Concern with the Bond Market?
For starters, the $59 trillion of debt in the U.S. right is a burden that has continued to grow, even since the financial crisis. With the prospect of rising interest rates, the total U.S. bond market has a worrisome risk/reward profile given record durations accompanying record low yields.
The U.S. Treasury market ended its 30 year bull market in 2012 when yields on the ten-year hit 1.39%. Going forward, who are will be the buyers of our debt? The Fed has ended its quantitative easing cycle, the world is already awash with $200 trillion in global debt, China has been dumping our Treasury shares hand over fist, raising capital to deal with its own bubbles.
Large exposure to mortgage back securities in a total bond index is troubling. The U.S. housing market has rebounded from rounds of money injected into the financial system. The problem is, homes have once again become unaffordable to many, even with low interest rates. According to the National Association of Realtor’s Home Affordability Index through October 2015, houses are the most expensive since June of 2006. Mortgage rates have climbed back from their low 3% range and look poised to move higher which could spell serious trouble for home values.
Corporate bonds, even though investment grade, are at the very late stages of an uptrend. Many of these investment grade issues, mostly financials and industrials, could drop into junk territory in a serious downturn. So many corporate bonds have been issued by S&P companies to take advantage of low rates and many have smartly pushed out the maturity on their debts. The problem is, these bonds have been packaged into collateralized instruments and been used to pay shareholders more dividends. Bondholders are left holding the bag of historically low yields at the face of an interest rate upswing and lofty market valuations. Rising interest rates pose a serious risk to their values, especially with extended durations.
How to Hedge a Bond Portfolio with a Total U.S. Bond Market Inverse ETF?
There is an inverse total bond ETF, SAGG (‘the moniker is Short Aggregate Bond Market’) to help reduce exposure to our current bond bubble. Issued by Direxion, SAGG aims to deliver the opposite (-1X) return of the Barclay’s Capital U.S. Aggregate Bond Index, on a daily basis. It would be used to hedge a broadly diversified bond portfolio. If an investor has a position in some of the large bond mutual funds such as PIMCO total return or the corresponding BOND ETF this might be a hedge to consider if you don’t want to exit that fund. If you own the mortgage-backed ETF (MUB), presumably for the yield, and you don’t want to sell it and lose the yield, you might consider using an inverse bond ETF like SAGG which can hedge some MBS exposure.
The only hesitation we have is the size of these inverse etfs-it’s quite small at only a few million in assets under management and pretty low trading volume. This could change if a sustained bond market sell-off ensues.
Another option is the SPDR DoubleLine Total Return Tactical Bond Fund (TOTL), an actively managed bond ETF. With over $1.1 billion in assets, it is clear investors are drawn to the reputation of DoubleLine and its star manager Jeffrey Gundlach. The theory behind this fund, as well as PIMCO’s Total Return Bond ETF (BOND) is that the managers can avoid some of the pitfalls of bonds, like rising interest rates, by reducing duration or nimbly rotating sectors, such as including more floating rate debt into their fund as a hedge.
The knock against active management is that it’s more expensive than passive investing. Also, most active managers underperform their passive benchmarks. But when markets turn lower, you’ll want to be in with a good active manager that can reallocate risk appropriately. So these actively managed funds may be better than a passive bond fund but at this point, still seems too risky to be long the U.S. bond market in any meaningful way.
Inverse Total Bond ETFs mentioned:
Actively Managed Total Bond ETFs mentioned: