A smart ETF approach to today’s bond markets

As we consider the risks in today’s fixed income markets, investors may be turning to smart beta bond exchange traded fund strategies to better position themselves for the unusual environment.

In the recent webcast Fixed income is back. Goldman Sachs strategies for 2023, Alexandra Lawson, fixed income portfolio manager at Goldman Sachs Asset Management, argued that US interest rates could peak as we approach the end of the Fed’s current rate hike cycle. The divergence between 2-year US Treasury yields and 10-year yields in the periods following a cycle of rate hikes can be challenging for investors, especially when it comes to reinvestment risk at the shorter end of the yield curve.

“For investors looking to generate income, we believe the relatively more stable returns achieved from the maturity extension will provide a more sustainable source of cash flow going forward,” said Lawson.

Looking ahead, investors may want to consider moving to the longer end of the yield curve, especially as long-term bonds have historically outperformed after the Fed’s rate hikes. Lawson noted that 24 months into the past three Fed interest rate cycles, the Bloomberg US Aggregate Bond Index has averaged more than double that of the shorter duration index. In addition, higher starting yields can make any further peaks less painful.

“These future yield benefits are equally powerful for munis, where we also see supportive fundamentals,” Lawson said. “As the calendar advances, investors may find attractive returns by adding maturity, both for municipal and taxable bonds.”

As we ponder ways to approach current markets, Joshua Gorelik, senior manager, FIMA Index Applied Research at FTSE Russell, emphasized a rules-based approach to active portfolio construction. He focused in particular on the FTSE Russell Smart Beta Indices.

FTSE’s strategy is to establish fixed income factors determined by testing and empirical evidence to achieve an active style framework in a passive environment, implemented through rule-based index construction. Through the use of bond screens and optimizations, FTSE Russell has developed numerous systemic strategies considering fixed income factors that have demonstrated proven performance aligned to different market cycles.

“The development of ETFs based on smart beta indices enables investors to directly and transparently access multi-factor investment strategies with enhanced risk-return profiles,” said Gorelik.

Gorelik particularly highlighted the quality, carry and taste/liquidity factors in the fixed income sector. Bonds issued by lower quality companies tend to perform worse and carry more risk. Bonds with higher moving yields generally outperform bonds with lower yields. Finally, less experienced bonds can be more expansive and underperform similar bonds with similar maturities and maturities.

Gorelik explained that depending on the type of screen, the smart beta strategy is designed to eliminate or mitigate uncompensated risks. For example, the quality screen is designed to reduce exposure to credit risk of issuers that are most vulnerable and subject to underperformance, while also reducing overall portfolio volatility. The seasonal screen showed that a liquidity premium is paid for the last issued government bonds, negatively impacting performance. In addition, a herbal screen applied to mortgages (in combination with convexity considerations) can serve as an indirect method of reducing the risk of prepayment. Carry optimization can identify specific parts of the term structure to maximize the expected return while the term still matches the base. Meanwhile, the liquidity screen serves as a mechanism to minimize exposure to the least liquid issues subject to distressed prices during times of market stress.

“These approaches offer an advantage across different market cycles,” added Gorelik.

Goldman Sachs Asset Management offers a range of Access ETF strategies to provide intelligent market exposure with a focus on risk-adjusted returns through a competitive, transparent investment vehicle. The suite includes the Goldman Sachs Access US Aggregate Bond ETF (GCOR)the Goldman Sachs Access Investment Grade Corporate Bond ETF (GIGB)the Goldman Sachs Access Investment Grade Corporate 1-5 Year Bond ETF (NYSEArca: GSIG)the Goldman Sachs Access High Yield Corporate Bond ETF (GHYB)the Goldman Sachs Access Ultra Short Bond ETF (GSST)the Goldman Sachs Access Treasury 0-1 Year ETF (GBIL)the Goldman Sachs Access Inflation Protected USD Bond ETF (GTIP) and the Goldman Sachs Access Emerging Markets USD Bond ETF (GEMD).

Lawson noted that investors can use GBIL and GTIP to target interest rate markets. GCOR can be used for exposure to multiple sectors. Finally, GSST, GIGB, GSIG, GHYB, and GEMD can help investors target credit markets through varying levels of exposure to both maturity and credit risk.

Access ETFs attempt to provide investors with exposure to a particular asset class or market beta.

“We aim to enhance exposure to the market beta rather than redefine it and look for intelligent methods to achieve this exposure,” said Lawson.

Access ETFs target risk-adjusted returns by minimizing exposure to tail risk in fixed income markets.

“We believe that the application of liquidity criteria, a technical or fundamental screening, can minimize exposure to less liquid or fundamentally stressed securities,” added Lawson.

Financial advisors who want to know more about the fixed income market can watch the webcast here on demand.