This article was first published to Systematic Income subscribers and free trials on May 18.

A big part of income-driven investing is about maximizing the returns offered while minimizing the risks investors are exposed to. to take to achieve these returns. In this article, we take a look at futures ETFs in high-yield, investment-grade, and tax-exempt sectors and highlight how investors can get the bulk of the yield while minimizing their exposure to duration.

Specifically, we highlight two high-yield corporate bond ETFs with worst-case portfolio returns after a 7% fee that also feature durations well below the most popular sector funds.

A case for bonds

In the current environment of short-term rate hikes, a gap of more than 7% between the Fed’s key rate and inflation and Fed Chairman Powell firmly stating that they will not stop to climb until inflation is kept under control, it doesn’t take a genius to suggest that having some allocation to floating rate assets makes a lot of sense in portfolios. And our own income portfolios have significant floating rate exposure through exchange-traded loans through CEFs, private loans through BDCs, and Fix/Float Preferred Shares.

However, in our view, it also makes sense to also have an allocation to fixed rate assets. This is for several reasons. First, despite the fact that the Libor has already fallen from near zero to 1.4%, loans are yielding significantly less than high yield corporate bonds. This has to do with the fact that while longer-term rates have risen sharply, Libor will only rise gradually over the next year as the Fed continues its gradual hikes.

Second, Libor resets quarterly, so many loans are currently accumulating coupons at Libor levels that have been set for the past 3 months, which could be as low as 0.5%.

Third, with recession estimates rising seemingly daily, Treasury yields should decline as they have tended to in past recessionary environments, which will help HY bonds, not loans.

Finally, loan issuers are much more likely to be stressed by rising short-term rates because not everyone will hedge their interest rate exposure. According to to PIMCO, for a typical single-B borrower, a 3% increase in the Fed Funds rate (consensus at present but below the estimates of certain commentators such as the former president of the NY Fed Bill Dudley who think it could easily reach 4-5%) will increase interest expense by 60-70%, making it much more difficult for them to generate free cash flow given that their interest coverage ratios (EBITDA/interest) are already about 2 x.

Overall, in our view, it makes sense to hold both floating rate exposure and fixed rate exposure. The key question is how much duration risk should investors take to maximize their returns?

Introducing Futures ETFs

Term ETFs are funds that hold bonds maturing in roughly a given year. The advantage of these products is that investors can tailor the fund’s return to its duration and credit risk. This contrasts with funds that hold securities with a combination of maturities.

In this article, we take a look at the following funds:

• Invesco BulletShares ETFs
• BlackRock iBonds ETFs

Both BulletShares and iBonds have premium corporate funds, high-yield companies, and premium tax-exempt municipal funds. Fees are similar – IG funds for both charge 0.10%, Muni funds charge 0.18% and iBond HY funds charge 0.35% while BulletShares charges 0.42%.

All funds are passive and are periodically rebalanced according to their indices which are different between the two fund managers, although they most likely have significant overlaps.

Find the right place

The chart below plots the funds’ worst-case net returns (y-axis) against their duration (x-axis). Net yield at worst is defined simply as the fund’s portfolio yield at worst minus the fund’s expenses. This number is what the investor will earn on their capital in the fund, before any default or portfolio turnover. It is important to point out that this is not what the fund distributes, but it is the cleanest measure of investors’ “return”. Both fund managers’ HY funds are shown in red, IG funds in green and Muni funds in orange.

The chart shows some interesting things. The first is the obvious fact that HY funds (red dots) have higher returns than IG funds (green dots) which have higher returns than tax exempt funds (orange dots).

Second, yields are sloping upwards – longer-term funds tend to have higher yields. This makes sense because both the Treasury yield curve and the credit spread curve are upward sloping, at least initially.

Third, the yield curve for HY funds rises but falls quite rapidly after around 2025. In our view, this is the most important lesson of the chart. The key point here is that the sweet spot for HY bonds is between 2024 and 2026. Investors who hold bonds with longer maturities do not earn higher yields and simply take on more duration risk.

Obviously, if risk-free rates come back all the way down, longer term funds will outperform, but not if lower rates are also accompanied by a much faster rise in credit spreads, which seems the most likely scenario. likely if risk-free rates go down. In short, shorter-duration funds not only protect investors against rising Treasury yields, but also against rising credit spreads. These funds will not emerge unscathed, but they will be less impacted by the rise in yields.

In our opinion, the following two funds offer value to investors:

• iShares iBonds 2024 Term High Yield and Income ETF (IBHD) to a net yield at worst of 7.03%. IBHD has an effective duration of 1.9 and a weighted average maturity of 2.07 years.
• iShares iBonds 2026 Term High Yield and Income ETF (IBHF) to a yield of 7.42% at worst. IBHF has an effective duration of 3.2 years and a weighted average maturity of 3.84 years.

By comparison, the benchmark SPDR Bloomberg High Yield Bond ETF (JNK) has a duration of 4.27, while the largest HY Bond CEF, the BlackRock Corporate High Yield Fund (HYT), has a duration of 5. 28. These funds also have higher fees than ETFs.

To give a different perspective on this, the chart below plots the funds’ total year-to-date return against their net YTW. We can see that IBHF and IBHD have held up much better than most of their peers despite similar returns.

Take away food

A big part of income investing comes down to earning the highest possible return while taking on the least amount of risk. That’s why it makes perfect sense to carefully examine the yields offered across different credit asset classes and different maturity profiles. Investors who want to increase duration risk because they think yields will fall will want to hold the longer bonds. However, most income-oriented investors will likely want to minimize the duration risk they need to take in the current environment while meeting their return targets.