A Novel Way to Play the Reflation Trade

kevin-temp2
Head of Fixed Income Strategy
Follow Kevin Flanagan
01/21/2021

I know it’s only three weeks into the new year, but the unmistakable trend in bond land thus far has been the ‘Reflation Trade.’ Sure, we could all debate whether this theme will continue in 2021 (I believe it will), but more importantly, ask yourself this question: Should I position my fixed income portfolio for the possibility of further increases in Treasury (UST) yields? It really is more of a rhetorical question, don’t you think?

As I’ve noted before, the fundamental and technical analyses still point toward the UST 10-Year yield rising from where it stands now. Yes, it broke through the 1% threshold rather easily and sooner than most expected, but that may just be the tip of the iceberg. I’m not calling for a 2% 10-Year yield (at least not now, anyway), but a move toward 1.50% does seem possible. The bond market appears to have quickly moved on from any potential economic soft patch that could be coming from the second wave of COVID-19, with last week’s response to the weaker-than-expected jobs report being exhibit A. And if the economy bounces back sooner than anticipated due to the potential for another hefty fiscal stimulus package (do I hear $1.9 trillion?) to be enacted once the Biden administration takes hold, my recommendation would be to take out some rate-hedge insurance.

So, what type of interest rate hedge insurance are we talking about here? Allow me to introduce a unique WisdomTree strategy on this front, specifically, the WisdomTree Interest Rate Hedged U.S. Aggregate Bond Fund (AGZD). This approach combines a long position in bonds representative of the well-known benchmark, the Bloomberg Barclays U.S. Aggregate Bond Index (the Agg), with a short position in Treasury securities to target zero duration.

Why AGZD?

  • Zero-duration aspect eliminates the potential for further rising rate risk
  • Follows an investment-grade strategy to maintain a traditional credit risk profile
  • Offers a 30-day SEC yield that is only marginally below the Agg but without the historically high duration of the Agg

When to Use AGZD?

While we haven’t yet seen the ‘whites of the eyes’ of inflation, inflation expectations have moved visibly higher. Former Federal Reserve (Fed) Chair Greenspan once noted that actual inflation readings can be akin to looking in the rearview mirror. With that in mind, implementing our AGZD strategy now seems to be a prudent course of action because the UST 10-Year yield will not necessarily wait to see those whites of the eyes of inflation in order to move higher—the first three weeks of 2021 being exhibit B.

 

Important Risks Related to this Article

There are risks associated with investing, including the possible loss of principal. Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. The Fund seeks to mitigate interest rate risk by taking short positions in U.S. Treasuries (or futures providing exposure to U.S. Treasuries), but there is no guarantee this will be achieved. Derivative investments can be volatile and these investments may be less liquid than other securities, and more sensitive to the effects of varied economic conditions. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner, or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. The Fund may engage in “short sale” transactions of U.S. Treasuries where losses may be exaggerated, potentially losing more money than the actual cost of the investment and the third party to the short sale may fail to honor its contract terms, causing a loss to the Fund. While the Fund attempts to limit credit and counterparty exposure, the value of an investment in the Fund may change quickly and without warning in response to issuer or counterparty defaults and changes in the credit ratings of the Fund’s portfolio investments. Investing in mortgage- and asset-backed securities involves interest rate, credit, valuation, extension and liquidity risks and the risk that payments on the underlying assets are delayed, prepaid, subordinated or defaulted on. Due to the investment strategy of certain Funds they may make higher capital gain distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.

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About the Contributor
kevin-temp2
Head of Fixed Income Strategy
Follow Kevin Flanagan
As part of WisdomTree’s Investment Strategy group, Kevin serves as Head of Fixed Income Strategy. In this role, he contributes to the asset allocation team, writes fixed income-related content and travels with the sales team, conducting client-facing meetings and providing expertise on WisdomTree’s existing and future bond ETFs. In addition, Kevin works closely with the fixed income team. Prior to joining WisdomTree, Kevin spent 30 years at Morgan Stanley, where he was most recently a Managing Director. He was responsible for tactical and strategic recommendations and created asset allocation models for fixed income securities. He was a contributor to the Morgan Stanley Wealth Management Global Investment Committee, primary author of Morgan Stanley Wealth Management’s monthly and weekly fixed income publications, and collaborated with the firm’s Research and Consulting Group Divisions to build ETF and fund manager asset allocation models. Kevin has an MBA from Pace University’s Lubin Graduate School of Business, and a B.S in Finance from Fairfield University.