Central banks have all begun to tighten policy in an effort to tame sharply rising inflation. Uncertainty around the timing of hiking cycles, and the risk of recession, have contributed to continued volatility in fixed income markets.
However, central banks all indicate a willingness to continue on this path until inflationary pressures come under control, which means a period of rising interest rates for at least the near term.
A rapidly changing environment
For more than 30 years, global developed market interest rates had been in a period of secular decline. The extreme low levels of recent years resulted from unprecedented monetary stimulus provided by central banks in response to the global pandemic. However, the rates backdrop has changed dramatically since the pandemic lows. In December 2021, the BoE became the first major developed market central bank to lift policy rates and other major central banks have followed. With inflation still at multi-decade highs, the expected path for rates is higher.
Because interest rates had been so low for so long, the transition to a rising rates cycle presents a challenge to investors who are looking to generate income but looking to insulate themselves from negative returns associated with rising yields.
How have markets responded?
In any market environment, rising interest rates will have negative repercussions for existing holdings in most traditional fixed income investments.
The extremely low levels on risk-free rates in the pandemic period forced investors to accept lower yields on some of their assets and to also seek yield in riskier securities.
The ICE BofA 1-3 Year US Corporate Index credit spread (Option-Adjusted Spread or OAS) index tightened significantly from 3.9% in March 2020 at the start of the pandemic to just 0.31% on 25 May 2021. The pattern is the same for sterling and euro spreads, where the OAS to government bonds for short-term corporate bond indices tightened substantially following the pandemic, as strong fundamentals and accommodative central bank policy supported credit markets.
Spreads started to widen as interest rates began to rise, and we expect spread volatility to increase from very low pandemic-era levels. The ICE BofA 1-3 Year US Corporate index credit spread (Option-Adjusted Spread or OAS) index has since increased and is now 0.83% on 20 September 2022. As investors sell fixed income securities in anticipation of higher rates, sales may not be limited to risk-free Treasuries, and credit products may see spreads widen even if corporate fundamentals remain relatively strong.
Insulating a fixed income portfolio
For investors with shorter investment horizons, mitigating potential volatility during the current rising rate environment is the key priority. As rates rise, these investors risk losing money from both higher rates and from widening credit spreads if they have not hedged their portfolios effectively.
To that end, it is vital to consider the key elements of investing in a rising rate environment – duration, income and credit spread exposure.
One way of managing interest rate duration, credit duration and income is to employ an ultra-short duration strategy. Our ultra-short income ETFs typically have a duration between three months and one year, are measured against a short-term benchmark and exhibit lower performance volatility than short-term bond funds.
The ETFs are also appropriate for those fixed income investors in longer-duration strategies who are looking to mitigate interest rate risks associated with this area of the market. Ultra-short duration strategies naturally provide some insulation from the capital losses incurred by rising interest rates. Investors can also benefit from higher yields sooner, given that ultra-short duration strategies invest in bonds with shorter maturities.
We believe active management is key for investors looking to navigate the uncertainty and volatility caused by the spectre of rising rates.
Our active ultra-short duration strategies, managed by professional portfolio managers using dedicated proprietary credit research, can seek to take advantage of market opportunities and mitigate risk by managing duration, sector rotation and security selection.
JPM Ultra-Short Income ETF solutions
J.P. Morgan’s Ultra-Short Income ETFs aim to generate returns above money market funds, while maintaining a high level of liquidity, by investing across a diversified basket of high-quality, short-maturity bonds and debt instruments.
The ETFs provide access to the active security selection and credit research expertise of one of the world’s largest liquidity managers, combined with the trading, cost and transparency benefits provided by the ETF wrapper. Lastly, from an ESG perspective, the ETFs are categorised as Article 8.
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here.
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