Traditionally, institutional investors have used individual bonds to implement barbell strategies, which allocate to both long and short duration strategies to manage interest rate risk.
However, this approach is time consuming, costly and requires investors to trade a lot as securities mature, Morgane Delledonne (pictured), ETF investment strategist at BMO GAM, tells Portfolio Adviser.
Via ETFs even retail investors would be able to employ the strategy, Delledonne says.
“If you buy a short-dated ETF, securities will be rolled automatically so you don’t have to manage this aspect of the strategy.
“Also, if your investment outlook changes and you want to adjust your duration target, then you just have to add on or sell a little bit on each ETF, whereas if you have different bonds you will have to consider the liquidity of each bond, maintain duration and maintain the credit risk characteristics.”
Creating an ETF barbell portfolio
Investors could use just two ETFs to create a barbell allocation, says Delledonne.
Explaining how to implement the strategy, she says: “It’s important to determine your views on duration and set a duration target. Then you can play around with the weight of different maturity buckets so it matches the average weight to your target. The idea is to use long-dated bonds for the extra income and short-dated bonds for capital preservation.”
In the current market environment, she says duration risks are receding while credit risks rise due to trade war threats and the approaching end of the market cycle. Therefore, investment grade products with differing maturity buckets are a suitable way to implement a barbell strategy, she says.
For example, a nearly even mix of the BMO Barclays 1-3 year Global Corporate Bond Ucits ETF and the BMO Barclays 7-10 year Global Corporate Bond Ucits ETF has outperformed the Bloomberg Barclays Aggregate Corporate Index over the past eight years, she noted in a BMO GAM blog post earlier this year. This is despite the barbell strategy and the aggregate index both having duration of 4.3 years.
Options proliferate on bond ETF growth
“ETF barbell strategies are relatively new just because the fixed income ETF space is relatively new compared to what you’ve seen in equities,” says Wisdomtree senior fixed income strategist Kevin Flanagan.
While fixed income products represented just $600bn at the end of 2016, it is projected to be one of the strongest areas of growth for ETFs in the medium term with EY predicting assets will hit $1.6trn by 2020.
A proliferation in bond products plus central bank normalisation will result in more investors employing ETF barbell allocations, Flanagan says.
“A blend we would look at would be a floating rate type of structure versus something that is further out in duration, such as a yield enhanced type of structure. You could also do a more traditional short duration type of vehicle,” he says. The Bloomberg US Treasury Floating Rate Bond Index and the Bloomberg Barclays US Aggregate Enhanced Yield Index were examples he pointed to in his own blog post from August.
Delledonne reckons maturity bucket products have been the product development that has most aided the growth of ETF barbell strategies. BMO GAM first launched such products in November 2015.
Hedging doesn’t make a lot of money
Barbell strategies would have delivered in the year to date, says Charles Stanley fixed income manager Jeremy Spain.
Although Spain, who runs the Monthly High Income fund with Chris Ainscough, doesn’t invest in ETFs, but says they could be a cost-effective way to implement a barbell. He suggests an investor could use a high yield ETF for their short-duration allocation and long-dated government bonds for the other end of the barbell. These allocations would have about four years duration at the short end and up to 14 years at the long end.
“High yield performed well and just recently the longer term govvies have taken a bit of a hit and therefore you do lose a bit.” That is why it has worked, he says. “It doesn’t make you a lot of money because it’s almost the perfect hedge.”
But he questions whether now is the time to implement a barbell strategy.
Although he expects one or two more hikes from the US Federal Reserve in 2018, he reckons populists in Italy could make the European Central Bank (ECB) more dovish while the Bank of England is unlikely to hike until the end of 2019 due to Brexit uncertainty.
He says: “A barbell strategy is something people can still do, but you might not want to enter it just now until interest rates pick up. You may want to wait until the end of the year.”