3. Municipals and Emerging Markets Snapback – Two of the most beaten down sectors of the bond market this year have been municipals and emerging markets which offer their own unique benefits and perils. Municipal bonds garnered negative headlines this year on the back of a bankruptcy filing by the city of Detroit. That combined with the headwind of rising interest rates set this sector back significantly. Emerging market bonds were largely dumped due to the severe underperformance of both equities and currencies in underdeveloped overseas markets.
However, often times the biggest decliners are the ones who snap back the hardest. Consider that the iShares National Municipal Bond ETF (NYSEARCA:MUB) and iShares Emerging Market Bond ETF (NYSEARCA:EMB) jumped 2.79% and 3.15% respectively in the month of September. Performance like that is typically reserved for equity-like positions. Both of these ETFs carry an effective duration of over 7 years, which contributed to the push higher when interest rates fell last month.
Right now I am continuing to avoid exposure to these sectors in favor of sticking with fixed-income holdings that offer better relative performance and shorter durations. I would be using this short-term strength to sell any lingering exposure and look to rotate into more defensive holdings.
4. Convertible Bonds Stealth Advance – One sector of the bond market that hasn’t received a great deal of attention lately are convertible bonds. These hybrid instruments carry characteristics of both equities and bonds by giving a bond holder the option to swap for common stock at a specified strike price. The SPDR Barclays Convertible Bond ETF (NYSEARCA:CWB) has been on a stealth climb higher since the beginning of the year with very little relative volatility. According to Index Universe, this ETF has added over $600 million in new assets and gained over 14% in total return this year.
Right now I only have limited exposure to this sector through the actively managed Osterweis Strategic Income Fund (OSTIX), which carries a small slice of convertible bonds. However, I am wary about allocating additional money near the highs right here. I would rather wait for a pullback to enter an exchange-traded fund such as CWB that has specific exposure to this sector. The caveat will be that the market can withstand the current political turmoil to finish the year strong. If we see a deterioration of economic fundamentals, then convertibles may get dragged down into the mud with stocks.
The Final Word
No matter how your portfolio is currently position, remember to check in regularly on your fixed-income holdings to ensure that they are providing you with adequate income and protection versus their peers. Often times it is very easy to switch to a comparable fund with a lower duration or another sector that is performing much better. I don’t subscribe to the theory that “all bonds are bad” in the face of rising interest rates. There are always going to be opportunities and trends that present themselves over the next several months and years. You need to have a keen income strategy to detect these trends and then capitalize on them when the timing is right.
This article is brought to you courtesy of David Fabian from FMD Capital Management.