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Our outlook for 2018 is characterized by the continued normalization of interest rates in both the U.S. and Europe, and the U.S. Federal Reserve has already signaled more aggressive rate hikes to come. This environment favors reduced exposure to developed markets rates, which are still low but rising, and reducing duration. We feel that combining emerging markets local currency bonds with floating rate investment grade bonds can allow investors to position their fixed income portfolios for this current environment.
Unlike a traditional barbell which is based on maturity, this approach is primarily risk-based. It combines the diversification and yield potential of emerging markets bonds with the relative safety of U.S. dollar denominated investment grade corporate debt that also has a duration of nearly zero. Although these two asset classes are divergent in many ways, they share a common trait that is crucial in today’s environment: low or negative return correlation to U.S. treasury bonds.1
Over the past year, the barbell portfolio would have performed similarly to a portfolio that used traditional fixed rate corporate bonds for its corporate exposure on an absolute basis, and outperformed on a risk-adjusted basis. Although there is a give-up in yield, returns benefitted from the lower duration.
A barbell portfolio for the current environment
As of March 31, 2018
Source: J.P. Morgan, MVIS, ICE Data Indices, LLC and Morningstar, as of 3/31/2018. EM Local Bonds is represented by the J.P. Morgan GBI-EM Global Core Index. US IG Floating Rate is represented by the MVIS® US Investment Grade Floating Rate Index. US IG Fixed Rate Corporate Bonds is represented by the ICE BofAML US Corporate Index. Index returns are not representative of fund returns. Past performance is no guarantee of future results. Indices are unmanaged and are not securities in which an investment can be made. See below for index description.
In the current environment, we continue to favor the barbell approach. In addition to being better positioned against rising interest rates in the U.S., this portfolio may benefit from other global tailwinds. For example, although credit spreads are tight relative to historical averages, they may be justified given the current benign environment, and we expect positive fundamentals to remain supportive of U.S. credit. Further, we do not see a clear catalyst for renewed U.S. dollar strength in the near term, while synchronized global growth, rising commodity prices and improved fundamentals continue to support emerging markets local currencies.
1Source: Morningstar, as of 3/31/2018. Based on 3-year monthly return correlation of the J.P. Morgan GBI-EM Global Core Index, MVIS® US Investment Grade Floating Rate Index, and ICE BofAML US Treasury Index.
Correlation is a statistic that measures the degree to which two securities move in relation to each other.
Yield represents the average yield to worst, which measures the lowest of either yield-to-maturity or yield-to-call date on every possible call date.
Duration represents the average effective duration, which measures a bond's sensitivity to interest rate changes that reflects the change in a bond's price given a change in yield. This duration measure is appropriate for bonds with embedded options.
1-year Standard Deviation is a statistical measurement of dispersion about an average, which depicts how widely the returns varied over a certain period of time.
1-year Sharpe is a measure that indicates the average return minus the risk-free return divided by the standard deviation of return on an investment. The higher the Sharpe Ratio, the better the fund's historical risk-adjusted performance.
J.P. Morgan GBI-EM Global Core Index is comprised of bonds issued by emerging market governments and denominated in the local currency of the issuer.
MVIS® US Investment Grade Floating Rate Index consists of U.S. dollar denominated floating rate notes issued by corporate issuers and rated investment grade by at least one of the three rating services: Moody's, S&P or Fitch.
ICE BofAML US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market.
ICE BofAML US Treasury Index tracks the performance of US dollar denominated sovereign debt publicly issued by the US government in its domestic market.
The information herein represents the opinion of the author(s), but not necessarily those of VanEck, and these opinions may change at any time and from time to time. Non-VanEck proprietary information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Not intended to be a forecast of future events, a guarantee of future results or investment advice. Historical performance is not indicative of future results. Current data may differ from data quoted. Any graphs shown herein are for illustrative purposes only.
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Please note that Van Eck Associates Corporation serves as investment advisor to investment products that invest in the asset class(es) included in this commentary.
Diversification does not assure a profit or protect against a loss. Debt securities carry interest rate and credit risk. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. Credit risk is the risk of loss on an investment due to the deterioration of an issuer's financial health. Securities may be subject to call risk, which may result in having to reinvest the proceeds at lower interest rates, resulting in a decline in income. International investing involves additional risks which include greater market volatility, the availability of less reliable financial information, higher transactional and custody costs, taxation by foreign governments, decreased market liquidity and political instability. Changes in currency exchange rates may negatively impact a fund's return. Investments in emerging markets securities are subject to elevated risks which include, among others, expropriation, confiscatory taxation, issues with repatriation of investment income, limitations of foreign ownership, political instability, armed conflict and social instability.
Investing involves risk, including possible loss of principal. Bonds and bond funds will decrease in value as interest rates rise. An investor should consider investment objectives, risks, charges and expenses of any investment strategy carefully before investing. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of Van Eck Securities Corporation.