It’s widely expected that the Federal Reserve will cut interest rates next month, perhaps by as much as 50 basis points. That would potentially provide a much needed positive jolt to bonds and fixed income ETFs.
Advisors and investors looking to position for lower rates may want to consider the benefits of active management. Enter the ALPS/SMITH Core Plus Bond ETF (SMTH). The fund debuted last December and already has north of $873 million in assets under management. That indicates it’s one of the more impressive, unheralded growth stories among bond ETFs.
More important than heft is the point that SMTH is pertinent at a time when it could be appropriate to add duration. Historically, it’s been best to add duration to a bond portfolio ahead of Fed rate cuts. And specific to SMTH, the actively managed ETF’s effective duration of 6.47 years is intermediate-term range. That’s long enough to benefit from rate reductions. But not so long as to be highly vulnerable to rate hikes.
Why SMTH Matters Now
Unlike an index-based counterpart, SMTH’s managers can swiftly adjust the portfolio to be responsive to no new interest rate or credit quality regimes. That’s advantage to consider over the near term.
“Looking at data back to the mid-1980s, extending duration one month before the first Fed rate cut instead of one month after has resulted in up to 5% greater returns over the subsequent year,” noted Adam Kuerbitz, fixed income specialist at J.P. Morgan Private Bank.
Another reason ETFs such as SMTH could be attractive to income investors over the near term is that bond funds are more positively levered to rate cuts than cash instruments. Yes, cash is as safe as it gets. But it offers investors no leverage to lower rates. In fact, lower interest rates make CDs and money markets less appealing than bonds.
“It may be tempting to remain in cash and briefly pick up about an additional 50 bps of yield compared, say, to a strategy that tracks the Bloomberg U.S. Aggregate Bond Index, a broad bond market index with a 6.2-year duration position. However, there is a risk of missing out on potential greater returns following the first rate cut,” added Kuerbitz.
Investors who are on the fence about cash or bonds today should talk with advisors about the potential benefits of considering ETFs such as SMTH now. That’s a valid issue to discuss. That’s because there is some risk to being devoted to cash when rates fall.
“By remaining in cash, clients could miss what could potentially be in our view the most significant driver of fixed income returns since 2007. One sign the cycle is turning: Since July 1, the Bloomberg U.S. Aggregate Bond Index has returned 3.58% compared with a 0.54% return from a three-month Treasury bill index,” concluded Kuerbitz.
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