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Weathering The Market Volatility Storm; Clear Skies On The Horizon For High Yield

By Darrin Smith, Portfolio Manager, Principal Global Fixed Income Since the beginning of June, high yield spreads have widened by over 150 basis points (bps). The energy sector is trading above 1,000 bps, blowing past the December wides. And although the rest of the high yield sectors have held up, no sector has been immune to market volatility. In light of recent market events, a good question to ask is: “Is this the beginning of a recession or just growth scares caused by a slow-down in China?” Our high yield team believes the latter, but in the current market environment, it’s not easy. But keep in mind, we’ve seen the growth scare before (remember the double-dip scare from 2011). High yield has traded off hard from May to August in recent years, so this mid-year volatility is nothing new. We expect volatility to continue into the first couple of weeks of September at the very least, but as current spreads approach 600 bps, we believe risk/reward is fairly attractive right now. Still, another good question is: “What role do the poor performing energy and metal sectors play in high yield’s ability to weather the volatility storm?” We understand the pain that’s been inflicted and will continue to be inflicted on the energy and metals sectors, but these sectors only represent 8.5% and 4.8%, respectively, of the total high yield index. We hear all the time about the headwinds in high yield being driven by the decline in energy prices, but this has mostly been an issue of oil supply rather than oil demand. For the rest of the sectors in high yield, $2 per gallon gasoline could provide a meaningful tailwind. Additionally, the underlying fundamentals of companies that are not in these sectors continue to be very robust (making the assumption this is just a growth scare and not the beginning of a recession). So where does this leave investors who are staring at a volatile market? Is there an end in sight? Our high yield team believes there will be volatility for at least another month given traditional poor performance of high yield during the late August/September timeframe and as we await further clarity surrounding the September Fed meeting. However, we do see spreads tightening from current levels heading into year end and into the first part of 2016. So, what are we doing in the interim in light of this forecast? Maintaining a Sector Focus: Our favorite sectors right now are finance, life insurance, leisure, automotive, and pharmaceuticals. For the most part, these sectors will benefit from reduced gasoline prices and are more tied to the consumer. The near-term default potential for these sectors is also very low. Establishing a Region Focus: We think European high yield offers value, as this segment has limited exposure to energy names and commodity weakness actually provides tailwinds for economic growth in the European high yield region. Examining our Sector Allocation: We are currently underweight energy. Nevertheless, we still have names that have been negatively impacted by the large sell-off in energy prices. We have not started buying back into the sector, but we are focusing on basins, balance sheets, and forward hedges (check out a previous post on this topic) that are in place for each company that we own. When we step back in, we will be adding to the higher-quality issues that have these positive characteristics. Evaluating our Credit-Rating Allocation: We are still overweight single-B’s, and we feel that our CCC’s have been rated incorrectly by rating agencies and should actually be rated higher. We will not call a bottom right now, but since the end of the financial crisis, the high yield market sells off during this timeframe every year. If our view is correct, and this is just a temporary growth scare, we believe the risk/reward is attractive right now, as long as you can withstand volatility over the next few weeks.

5 ETF Strategies To Prepare For Higher Rates

With an improving economy and an accelerating job market, the prospect of interest rates hike is moving closer, despite global growth concerns. The Fed indicated its confidence in the economy in the latest FOMC meeting, and confirmed that it is on track to raise the interest rates for the first time since 2006, sometime later this year. In fact, Atlanta Fed President Dennis Lockhart yesterday stated that the interest rates hike could come as early as next month. This is especially true given that the first-quarter slump in the U.S. seems to have been tided over with 2.3% economic expansion in the second quarter. The economy created at least 200,000 jobs in 13 of the past 15 months, with broad-based gains and unemployment dropping to the seven-year low of 5.3%. Further, economic activity has been rising moderately, consumer confidence and spending has increased, and the housing market is seeing frenzied demand for homes. While the overall economy is gaining momentum lately, subdued inflation, lower business investments and soft exports continue to weigh on economic growth. As such, uncertainty still looms around the timing of interest rates. The Fed also indicated that the path of rate hikes would be gradual, meaning that the Fed will take baby steps once it embarks on the trail of increases. Given this, investors should be well prepared to protect themselves from higher rates, albeit at a slower pace. Here are a number of strategies that could prove extremely beneficial for ETF investors in the rising rate environment: The Financial Sector Remains a Hot Spot A rising interest rate scenario would be highly profitable for the financial sector. This is because the steepening yield curve would bolster profits for banks, insurance companies and discount brokerage firms. A broad way to play this trend is by using the Financial Select Sector SPDR Fund (NYSEARCA: XLF ), which has a Zacks ETF Rank of 1, or a ‘Strong Buy’ rating. Other top-ranked funds targeting the niche segment of the broad financial sector are the SPDR S&P Regional Banking ETF (NYSEARCA: KRE ), the SPDR S&P Bank ETF (NYSEARCA: KBE ) and the PowerShares KBW Capital Markets Portfolio ETF (NYSEARCA: KBWC ). These funds have a Zacks ETF Rank of 2, or a ‘Buy’ rating. Hedge with Niche Bond ETFs Though the fixed-income world is the worst hit by the rising rates scenario, a number of ETFs that employ some niche strategies, like the PowerShares Senior Loan ETF (NYSEARCA: BKLN ), the iShares Floating Rate Note ETF (NYSEARCA: FLOT ) and the iPath US Treasury Steepener ETN (NASDAQ: STPP ) could lead to huge gains. This is because the senior loan funds are floating rate instruments, and thus, pay a spread over the benchmark rate like LIBOR, which help in eliminating interest rate risk. On the other hand, floating-rate note ETFs pay variable coupon rates that are often tied to an underlying index (such as LIBOR) plus a variable spread depending on the credit risk of the issuers. Since the coupons of these bonds are adjusted periodically, they are less sensitive to an increase in rates compared to traditional bonds. Further, the Steepener ETN directly capitalizes on rising interest rates. The note looks to follow the Barclays US Treasury 2Y/10Y Yield Curve Index, which delivers returns from the steepening of the yield curve through a notional rolling investment in U.S. Treasury note futures contracts. The fund takes a weighted long position in 2-year Treasury futures contracts and a weighted short position in 10-year Treasury futures contracts. Be Safe with Zero or Negative Duration Bonds Zero or negative duration bond ETFs provides exposure to traditional bonds, while at the same time short Treasury bonds using derivatives such as interest rate swaps, interest rate options and Treasury futures. The short position will diminish the fund’s actual long duration, resulting in a zero or negative duration. As a result, these bonds could act as a powerful hedge and a money enhancer in a rising rate environment. Currently, there are two zero duration and two negative duration bond ETFs from a single issuer – WisdomTree. The zero duration funds include the WisdomTree Barclays U.S. Aggregate Bond Zero Duration Fund (NASDAQ: AGZD ) and the WisdomTree BofA Merrill Lynch High Yield Bond Zero Duration Fund (NASDAQ: HYZD ), while negative duration fund include the WisdomTree Barclays U.S. Aggregate Bond Negative Duration Fund (NASDAQ: AGND ) and the WisdomTree BofA Merrill Lynch High Yield Bond Negative Duration Fund (NASDAQ: HYND ). AGND has duration of approximately negative 5 years, while HYND has negative 7 years duration. Beat the Market with ex-Rate Sensitive ETF Concerns over the rising interest rates are resulting in higher volatility in the market. In order to protect from both these issues, investors should consider the PowerShares S&P 500 ex-Rate Sensitive Low Volatility Portfolio (NYSEARCA: XRLV ). This fund provides exposure to 99 stocks of the S&P 500 that have both low volatility and low interest rate risk. It recently debuted in the space, and has gathered $63.9 million in its asset base within four months. Short Rate-Sensitive Sectors Investors worried about higher interest rates could also go short on rate-sensitive sectors like Utilities and Real Estate via ETFs. There are a number of inverse or leveraged inverse products currently available in the market that offer inverse (opposite) exposure to these sectors. While a leveraged play might be a risky option, inverse ETFs are interesting choices and provide hedging strategies in a rising rate environment. There are a handful of ETFs in this corner of the investing world. The ProShares UltraShort Utilities ETF (NYSEARCA: SDP ) is the only inverse ETF in the Utilities space employing a double-leveraged factor. In the Real Estate sector, there are three options – the ProShares Short Real Estate ETF (NYSEARCA: REK ), the ProShares UltraShort Real Estate ETF (NYSEARCA: SRS ) and the Direxion Daily Real Estate Bear 3x ETF (NYSEARCA: DRV ) – having leveraged factor of 1, 2 and 3, respectively. Original Post