The Great Duration Rotation Continues; But For How Long?
Matt Tucker: In an earlier post I examined the mysterious rise in interest rates that we have seen in the first quarter the past few years. Each year we’ve seen rates creep higher from January to March, and each year rates have ended December lower than where they started out earlier in the year. While we have no way of knowing if this will be the case again in 2013, ETF flows in Q1 definitely illustrated investors’ concerns that the slight rate rise we were experiencing was a taste of things to come. In particular, we saw large shifts within the fixed income ETF category as investors moved out of funds with more exposure to interest rates and into funds with less exposure. Here were the three most notable examples:
- Investment grade corporate bonds. We saw money come out of more rate sensitive funds like the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSEARCA:LQD), which lost $1.4bn. This is a big number, but LQD was still able to maintain its status as the world largest fixed income ETF with assets of $23.6bn. On the flipside, we saw flows into shorter funds like the iShares Floating Rate Note Fund (NYSEARCA:FLOT) which took in $483mn and the iShares Barclays 1-3 Year Credit Bond Fund (NYSEARCA:CSJ) which saw inflows of $874mn. Notice that the flows out of LQD are almost the same size as the flows into FLOT and CSJ.
- High yield bonds. A similar trend was observed in the high yield market. Flagship high yield funds such as the iShares iBoxx $ High Yield Corporate Bond Fund (NYSEARCA:HYG) lost money, with $595mn coming out in Q1. Conversely, money flowed into perceived less interest rate sensitive high yield segments like short-term bonds and leveraged loans.
- Emerging market bonds. Perhaps the most interesting of the examples was in emerging markets. The iShares J.P. Morgan USD Emerging Markets Bond Fund (NYSEARCA:EMB) saw $963mn of outflows, but in this case there are no short maturity EM bond funds in the market. Instead, we saw money go into local EM debt funds such as the iShares EM Local Currency Bond Fund (NYSEARCA:LEMB), which took in $222mn during the quarter. Since the bonds in these funds are denominated in the local currency of the emerging market issuer, they would not be directly impacted by a rise in US interest rates. This makes them an interesting defensive replacement for investors who are concerned about rising domestic interest rates but who are more constructive on local emerging market rates.
Notice that despite the rotation away from more rate sensitive investments, investors still showed a preference for yield and income. This is one of the interesting results of quantitative easing. Interest rates are low, and investors are concerned that they will rise, but people still have yield and income targets that they want to hit. For some investors this means that they have exchanged interest rate risk for credit and currency risk.
The great thing about all of the above flow data is that it is widely available in the market and updated on a daily basis. Because of this, fixed income ETF flows are increasingly being recognized as one of the best indicators of investor sentiment.
What will Q2 bring? With interest rates moving back down I expect that the shift into less interest rate sensitive funds will abate a bit, but the question is what will replace it. My guess is that investors will continue to stretch for yield, and that the flow pattern we observed in the second half of 2012 will resume: investors moving into higher yielding segments of fixed income across sectors. The piece I am not so sure about is whether investors will become comfortable that interest rates are not going to rise in the immediate future, and decide to move back into more interest rate sensitive funds. We shall see.