Fed Hikes: Hedge Your Rate Bets for 2017

Head of Fixed Income Strategy
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For the second year in a row, the Federal Reserve (Fed) has given the financial markets a rate hike in December. The natural question now is whether U.S. policy makers will follow this year’s playbook for 2017, or will they blaze a new trail and potentially raise rates more than once per year? The Fed’s new median forecast is for three rate hikes next year.
Certainly, the investment climate seems rather different than how it was 12 months ago, because the results of the U.S. presidential election have altered the dynamics of the financial markets. Within the fixed income arena specifically, the sell-off in the U.S. Treasury (UST) market after the election placed yields at levels investors haven’t witnessed in well over a year. In fact, in the case of the UST Two-Year and Five-Year notes, yield levels reached their highest readings in the last five to six years.
The prospect for fiscal stimulus in the guise of tax cuts, infrastructure spending and regulatory relief has created an investment landscape where improved economic growth and the potential for higher inflation have dominated investor sentiment. As far as the current economic landscape is concerned, real gross domestic product (GDP) has improved from the first half of this year, while inflation gauges, such as the Consumer Price Index (CPI), have seen some elevation in recent months as the drag from lower energy prices gets removed from year-over-year comparisons, and wage trends have revealed signs of improvement as well.
The aforementioned economic conditions were key reasons for the Fed’s latest tightening move. Where the voting members go from here is still subject to some uncertainty. Based on comments from a variety of Fed officials, they are not going to preemptively change their policy outlook based on the premise of upcoming fiscal stimulus. Rather, the Federal Open Market Committee (FOMC) seems to be entering more of a potential reactive phase to policy, with a tilt toward perhaps more rate hikes than Fed members currently envision if conditions warrant such action. 

Please click here for the standardized performance of the WisdomTree BofA Merrill Lynch High Yield Bond Zero Duration Fund.
Given today’s Fed outcome and the fixed income landscape being altered post-election, investors should examine their portfolios to ensure they are prepared for a potential volatile environment for the remainder of this year and into 2017. If fiscal stimulus, regulatory relief and additional Fed rate hikes are the base case for 2017, one should consider an approach to help mitigate potential interest rate risk.
The graph above clearly illustrates the importance of reviewing the need to help immunize a fixed income portfolio from potentially higher interest rates. Indeed, since the UST 10-Year yield reached its all-time low on July 8, investors who went unhedged and remained solely in a broad fixed income position as represented by the Bloomberg Barclays U.S. Aggregate Index (Agg) have witnessed a negative total return of more than 3%, as of this writing. In contrast, by dialing down rate exposure by using a zero duration strategy as represented by the BofA Merrill Lynch 0-5 Year US High Yield Constrained, Zero Duration Index, investors would have been able to reduce their risk of higher rates and see a positive total return of more than 6%, in the same time frame.
The WisdomTree BofA Merrill Lynch High Yield Bond Zero Duration Fund (HYZD), which tracks the BofA Merrill Lynch 0-5 Year US High Yield Constrained, Zero Duration Index, and the WisdomTree Barclays U.S. Aggregate Bond Zero Duration Fund (AGZD) are two vehicles investors could utilize to achieve this goal. These Funds can be used to complement a “core” fixed income strategy or as “stand-alones” for this approach.
Investors looking to mitigate potential interest rate exposure may also wish to examine the potential benefits of floating rate Treasury securities (FRNs). FRNs are based on a reference rate that is determined at the weekly Three-Month Treasury Bill auction. Given the potential for additional increases in the Federal Funds Rate in 2017, some potential “Fed protection” seems warranted. Against this backdrop, we feel that utilizing a floating rate product, such as the WisdomTree Bloomberg Floating Rate Treasury Fund (USFR), investors may be better able to insulate their bond portfolio compared with a more traditional fixed income investment. 
Unless otherwise noted, source is Bloomberg, as of 12/9/2016.


Important Risks Related to this Article

There are risks associated with investing, including possible loss of principal.  Securities with floating rates can be less sensitive to interest rate changes than securities with fixed interest rates, but may decline in value. The issuance of floating rate notes by the U.S. Treasury is new and the amount of supply will be limited.  Fixed income securities will normally decline in value as interest rates rise.  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.

Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations.  Derivative investments can be volatile and these investments may be less liquid than other securities, and more sensitive to the effect of varied economic conditions.  As these Fund can have a high concentration in some issuers, the Funds can be adversely impacted by changes affecting those issuers. 

Due to the investment strategy of these Funds it may make higher capital gain distributions than other ETFs.  Please read each Fund’s prospectus for specific details regarding each Fund’s risk profile.

For more investing insights, check out our Economic & Market Outlook


About the Contributor
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 Managing Director and Chief Fixed Income Strategist for Wealth Management. 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.