Two Bond ETFs Struggling In May

market bondsDavid Fabian: The “sell in May” phenomenon has been largely debunked this year as investors have continued to snatch up risk assets and push the market to all-time highs. Even the Fed raining on everyone’s parade this week did not introduce enough volatility to make a significant dent in year-to-date gains. However, there are two bond funds on my watch list for my income clients that have seen a significant change in their tenor over the last three weeks. These two funds are the iShares TIPS Bond Fund (NYSEARCA:TIP) and the iShares MBS Bond ETF (NYSEARCA:MBB).

TIPS Are Seeing Deflation

I first became concerned about TIP at the beginning of the month when it broke below its 200-day moving average. For trend followers and active managers, this is typically a sign of a fund that has lost its momentum and may be slipping into a new down trend.

So far this month, TIP has fallen -3.09% which is the most significant drop we have seen in treasury inflation protected securities in over a year. For comparison’s sake, the iShares Aggregate Bond Fund (NYSEARCA:AGG) has only fallen -1.28% over that same time period. One of the biggest hurdles that TIP has working against it right now is its relatively high average duration of 8.85 years which makes its price susceptible to a great deal of interest rate risk.

According to Index Universe, TIP has seen asset redemption’s of over $465 million just this month. This could be a sign of fixed-income investors heeding the warnings of reduced quantitative easing measures and looking to shorten the duration of their portfolios in anticipation of rising interest rates. The Vanguard Short-Term Bond ETF (NYSEARCA:BSV) has had over $3 billion in new asset inflows this year which confirms that bond investors are becoming more risk adverse.

It is important to point out that TIP will not protect your portfolio from the effects of rising interest rates, rather the principal value of this ETF will respond favorably to rising core inflation. That is an important distinction that I believe is misunderstood by many investors in these funds.

Don’t Bet Your House On It

The second area of the bond market that has taken a beating is the iShares MBS Bond Fund ETF. According to iShares, MBB invests in “U.S. agency mortgage-backed bonds, including Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA) and Freddie Mac (FHLMC) securities.”

These mortgage-backed securities are the very instruments (alongside Treasuries) that the Fed has been purchasing as part of its quantitative easing program. With the Fed hinting about tapering off its asset purchase policy, the demand for these securities is going to enter an uncertain phase.

As you can see on the chart above, MBB has fallen below its 200-day moving average and has broken its prior level of support. While the percentage drawdown has been relatively minor, the change in direction is what has me concerned about this sector of the bond market. When the Fed does begin to tighten its monetary policy, we could see additional downside in MBB. Unfortunately, it seems that all good things must eventually come to an end.

Three Changes for Income Investors to Consider

1. Shorten Duration. At our firm, we have been making subtle changes to our income portfolio structure to shorten the duration of our client accounts. One potential alternative for TIP is to use the iShares 0-5 Year TIPS Bond ETF (STIP) or the PIMCO 1-5 Year TIPS Index (STPZ). Both of these funds have a lower average duration and will be less susceptible to interest rate risk.

2. Security Selection. Unfortunately, there is no short duration alternative for MBB, so you can consider changing to a different ETF in the mortgage sector that has not had as much volatility. One such fund is the iShares CMBS Bond ETF (CMBS). This ETF invests strictly in commercial mortgage-backed securities and has a slightly lower duration and yield than MBB. For our clients we use the Doubleline Total Return Fund (DBLTX) as an active solution to mortgage securities.

3. Prepare for Rising Rates. It’s coming whether you want it or not. Now is the time to start preparing for rising interest rates on the horizon. We are currently evaluating several floating rate note funds such as the PowerShares Senior Loan Portfolio (BKLN) and the actively managed First Trust Senior Loan Fund (FTSL). These “floaters” have historically performed well in a rising rate environment.

There are many different strategies that you can use to manage the risk in your income portfolio, but the key is to make small tactical changes that can have a measurable impact on your performance. This will ensure that you don’t get caught in a position where your bond portfolio is overexposed to securities that can rapidly decline when interest rates begin to rise.

This article is brought to you courtesy of David Fabian from Fabian Capital Management.

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