A strengthening economy, lower tax rates and a growing need for income among retirees are compelling many advisors to focus more of their attention on optimizing their clients’ fixed income investments.
Ideally, a diversified portfolio of U.S. government and corporate bonds should be flexible and liquid enough to adjust to interest rate changes, yield curve variations, and changing credit spreads.
However, evaluating, purchasing and selling individual bonds can require a great deal of time and expense. And a number of risk factors, some systematic, and some specific to the bond market itself, have made the advisor’s role as steward of their clients’ fixed income portfolios more complex.
One after-effect of the financial crisis in 2008 was the increased issuance of bonds without a corresponding rise in investor demand. While this lack of liquidity has, in many situations, created attractive prices for purchasers, it has also created difficulty for some sellers, particularly those holding long-term bonds with lower yields.
Traditionally, investors have relied heavily on independent nationally recognized statistical rating organizations (NRSROs) to assess the credit risk of bond issuers. However, these credit rating agencies came under intense scrutiny during the financial crisis when high default rates among top-rated securities revealed numerous flaws and conflicts in NRSROs’ methodologies and business practices.
While the Dodd-Frank Act gave the SEC the authority to regulate NRSROs, few meaningful reforms have been enacted. This has compelled many investors and advisors to seek other ways to evaluate solvency and default risk, such as applying the kinds of data-driven credit scoring methodologies now used to evaluate applications for mortgages, auto loans and credit cards.
Duration is a measure of the sensitivity of the price -- the value of principal -- of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Bond prices are said to have an inverse relationship with interest rates. Therefore, rising interest rates indicate bond prices are likely to fall, while declining interest rates indicate bond prices are likely to rise. With the Fed likely to continue to raise interest rates to stave off inflation risk, duration risk is re-emerging as an important issue for many bond investors. Bonds with longer durations are more sensitive than bonds with shorter durations to changes in interest rates, which can increase the volatility of market prices.
Yield to Maturity Issues
While yield to maturity (YTM) can help advisors evaluate whether a particular bond is a viable investment, it has some limitations. First of all, YTM calculations are made on a pre-tax basis. Secondly, it assumes that the bond will be held to maturity, which is of limited use if the investor plans on selling the bond.
Meeting Investors’ Expectations and Challenges
Building and managing a diversified portfolio of bonds that can address each client’s income needs while mitigating various risk factors may be beyond the comfort level of many advisors.
While actively managed mutual funds enable investors to own many bonds with a single investment, most of these funds focus on specific slices of the market, such as Treasuries or high-yield bonds, each of which may be vulnerable to some of the risks mentioned above.
And while some bond funds invest across multiple bond classes, they often carry high investment expenses and can only be purchased at net asset value (NAV).
As an alternative, FlexShares combines the benefits of active management with the cost-efficiency, liquidity and transparency of ETFs in a single multi-asset-class fixed income solution: FlexShares Core Select Bond Fund (BNDC).
The Best of Active and Passive Management
BNDC primarily uses an “ETF of ETFs” approach to offer a broadly diversified and adjustable portfolio of fixed income investments. Its investment process is guided by top-down active management from Northern Trust:
Based on Northern Trust’s fixed income forecast and market outlook, BNDC uses a proprietary rules-based methodology to build and manage a diversified portfolio of Treasury and corporate bonds of various durations and credit qualities by investing primarily in passively managed fixed income ETFs from FlexShares and other firms.
FlexShares adjusts the weightings of the holdings over time to anticipate and react to changes in interest rates, the shape of the yield curve and credit spread relationships.
FlexShares’ approach is designed not only to generate income and total returns but to help manage the common fixed income risk factors previously discussed:
Monthly income. Most individual bonds pay out interest every six months. BNDC pays dividends from net investment income monthly, giving investors a more frequent source of regular income.
Broader diversification. By investing in multiple fixed-income ETFs, BNDC provides exposure to a wide range of U.S. government and corporate bonds with varying yields, durations, and maturities.
Greater liquidity and transparency. Unlike some individual bonds, which may trade as infrequently as once a month, BNDC trades on an exchange at prices that are updated constantly. And, unlike most bond mutual funds, BNDC publishes an updated list of all holdings every day the market is open.
Credit rate risk management. BNDCs holdings may include ETFs that use proprietary credit scoring methodologies to evaluate the solvency and default risk of their underlying bond investments.
Reduced duration risk. BNDC may invest in several FlexShares ETFs with fixed duration targets, and adjust their weightings to manage overall duration risk.
A Wake-Up Call for Fixed Income Investors
After a long period of accommodation, the Fed’s decision to gradually raise interest rates is motivating many advisors and investors to evaluate their fixed income investments. But additional factors such as duration, liquidity and credit quality risk and trading inefficiencies can increase the complexities of building and managing a portfolio of individual bonds. An actively managed solution such as BNDC may potentially provide investors the benefits of monthly income generation with reduced risks and costs.
Before investing, carefully consider the FlexShares investment objectives, risks, charges and expenses. This and other information is in the prospectus and a summary prospectus, copies of which may be obtained by visiting www.flexshares.com. Read the prospectus carefully before you invest.
Foreside Fund Services, LLC, distributor.
An investment in FlexShares is subject to numerous risks, including possible loss of principal. Fund returns may not match the return of the respective indexes. The Funds are subject to the following principal risks: asset class; authorized participant concentration; counterparty; credit/default; currency; debt extension; derivatives; emerging markets; financial sector; foreign securities; high portfolio turnover; inflation; interest rate/maturity risk; issuer; leveraging; liquidity; management; market; market trading; mortgage-related and other asset-backed; municipal market volatility; non-diversification; prepayment/call; U.S. government; U.S. issuer and valuation. A full description of risks is in the prospectus.
FlexShares Core Select Bond Fund is actively managed and does not seek to replicate a specified index. The Fund is subject to increased credit and default risk, where there is an inability or unwillingness by the issuer of a fixed income security to meet its financial obligations, debt extension risk, where an issuer may exercise its right to pay principal on an obligation later than expected, as well as interest rate/maturity risk, where the value of the Fund`s fixed income assets will decline because of rising interest rates. The Fund is subject to increased underlying fund risk, where the Fund`s investment performance and its ability to achieve its investment objective may be directly related to the performance of the Underlying Funds in which it invests.
The Fund may also be subject to increased concentration risk as it may invest more than 25%
of its assets into the securities of a single developed market. Additionally, the Fund may invest without limitation in mortgage or asset-backed securities, which puts it at increased risk for interest rate/maturity risk, debt extension risk, and prepayment (or call) risk.
Shares are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. Market performance is determined using the bid/ask midpoint at 4:00pm Eastern time. NAV return is determined using the daily calculated Net Asset Value (NAV).