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Using Momentum in a Fixed Income ETF to Navigate an Uncertain Market

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Using Momentum in a Fixed Income ETF to Navigate an Uncertain Market

It’s been a tough run for fixed income products lately. With interest rates on the rise and a stock market that, despite its new wave of intense volatility, has continued to fly high, the yield on fixed income products has fallen from a stable 5-6% down to below 3% today [1]. It’s a daunting challenge when working with clients who rely on income from fixed income investments to fill their retirement coffers.

Of course, the shift in the market is no surprise. The combination of a prolonged low interest rate policy, record debt issuance, and credit spread tightening since the financial crisis has caused a precipitous drop in yield. It’s common sense that as expansion fades, interest-rate risk and credit risk rise—both of which play heavily on fixed income returns. When you combine the Fed hikes and the increase in non-financial corporate leverage, it’s no wonder at all that fixed income investing is facing some headwinds.

Combating the rising risk in today’s uncertain market while maintaining the ability to generate income calls for anything but “investing as usual.” With the market behaving so unpredictably, it’s harder than ever to create portfolios that are able to lose less in the short term to make more over the long term. And while fixed income has typically been every advisor’s go-to tool for managing volatility, in today’s environment, passive fixed income investments simply aren’t doing the trick.

As an advisor, your goal is to give your clients confidence that their income needs will be met—no matter what surprises the market has waiting in the wings. There may have never been a smarter time for a rules-based fixed income ETF that uses momentum to determine when and where to invest.

Using ETFs to invest in fixed income is nothing new. In use for more than a decade, traditional passive core fixed income ETFs are making allocation decisions based on the current amount of debt outstanding within the five basic fixed-income building blocks: treasuries, mortgage-backed securities, investment-grade corporate bonds, high-yield corporate bonds, and emerging market bonds. Unfortunately, debt amount outstanding has no relationship to asset class performance, and so the old approach of buying issuers with the largest amount of debt outstanding isn’t enough to achieve optimal risk-adjusted returns. Alternatively, in a rules-based momentum strategy, allocation is based on the performance trend to take advantage of each asset class’s leadership position, which expands the ETF equation to help tackle that challenge.

If you’re surprised by the idea of using a momentum strategy in the fixed income universe, don’t be. While it’s true that the majority of the momentum products are in the equity space, there is plenty of academic research supporting the use of a momentum strategy in the fixed income market. Similar to their cousins in the equities world, the reason that a momentum strategy could deliver value is backed by investors’ behavior bias of chasing winners and avoiding losers. ETFs that use momentum-based dynamic allocation look at traditional fixed income sectors to identify short-term trends that impact fixed income returns. By looking through two distinct lenses, asset class and momentum, these ETFs are able to provide exposure to each key asset sector, while using momentum signals to overweight the best-performing sectors and underweight the worst-performing sectors. This dynamic allocation strategy seeks better risk-adjusted returns without taking on greater risk, making it well worth considering as a core fixed income investment.

Related: The Key to Smarter Investing: Smart Beta ETFs

One example of this strategy is an ETF that tracks the IQ Enhanced Core Plus Bond U.S. Index. Designed to capitalize on current trends in the market, the Index measures momentum by comparing a short-horizon (45-day) moving average of returns to a longer-horizon (90-day) moving average of returns for each fixed income sector. It also takes into account recent volatility of to enable fair comparison among sectors. The Index then weighs each sector based on their momentum strength to overweigh leaders and under weigh laggards.

Despite the fact that the Index was launched in May 2016, just as interest rates began to rise for the first time in over a decade, it has consistently outperformed the AGG [2]. Since inception until the end of 2017, it outperformed the AGG by 2.04% according to Bloomberg.

IndexIQ’s IQ Enhanced Core Bond U.S. ETF (AGGE) and the IQ Enhanced Core Plus Bond U.S. ETF (AGGP), both track smart beta-style indexes using a momentum approach to fixed-income markets. Click here to learn more.

IndexIQ® is the indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the IQ Hedge Multi-Strategy Plus Fund. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.
[1] Source: Morningstar, as of 2018.
[2] Source: Bloomberg, as of 2018.
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