Controlling Your Duration with Innovative ETFs

By Michael FabianNEW YORK (Fabian Capital Management) -- The volatility in interest rates this year has been particularly troublesome for fixed-income investors.

Much of the jump in long-term Treasury bond yields has been due to the quicker-than-expected improvement in the labor market, thereby putting pressure on the Federal Reserve to begin tapering its asset-purchase programs in 2013. The unrelenting rise in stock prices, combined with investors pouring assets into equity-oriented funds at a breakneck pace, has also put downward pressure on fixed-income sentiment.

This has been a wakeup call for investors to begin paying closer attention to their fixed-income holdings, and examine them for potential weaknesses.

Investors who own traditional core fixed-income funds now face a challenge: Continue to hang on, as rates creep higher and indexes ultimately rotate to higher-yielding bonds, or sell, and forego the cash-flow benefit of fixed-income altogether?

Investors who have a portfolio made up of individual bond issues have a very different set of concerns than holders of traditional bond funds. This is primarily because a fund will continue its duration into perpetuity, as there is no fixed maturity date. It will simply roll short-maturity holdings forward, based on the investment objectives of the fund.

Naturally the advantage to owning a fund is the ease of use and diversification you get for holding just one security in your portfolio.

Conversely, the obvious advantages to owning individual bonds is the ability to latter a basket of credits, and then allow them to mature at par. This enables the investor to participate in the income component, yet not get wrapped up in the pricing anomalies in relation to Treasury bonds.

Furthermore, after maturity, you have the option of either rolling proceeds over to higher-yielding bonds if a rising rate environment persists, or just sitting in cash to await better opportunities.

Several years ago, Accretive Asset Management launched the innovative BulletShares Indexes to offer a unique index methodology, in which bonds are grouped together based on their maturity date.

The BulletShares ETFs, currently managed by Guggenheim, continue to be based on the target-date fund philosophy designed to satisfy the needs of both individual-issue and bond-fund investors.

Accretive recently partnered with NASDAQ OMX Global Indexes to further develop the family and rebrand the indexes NASDAQ BulletShares Indexes.

As an example, the Guggenheim BulletShares 2016 Corporate Bond ETF ( BSCG) has a constituency of investment-grade bonds that will all mature in 2016, when the fund is set to be liquidated at yearend.

As the bonds mature within the fund, the proceeds will be placed in cash until it finally is liquidated and makes a full distribution to its shareholders. The index is designed to represent a held-to-maturity basket of bonds with all the benefits of diversification offered by a fund.

Practical uses within a portfolio can vary, and include the basic buy-and-hold to maturity approach, or even a more sophisticated yield-curve positioning strategy. Other uses can even include opportunistically shortening or lengthening duration, while staying in the same fund family to take advantage of prevailing interest rate fluctuations.

When the need arises for even large institutional portfolio managers to target a specific duration and/or credit quality within their portfolios, BulletShares ETFs offer the convenience of not having to curate an entire bond ladder from scratch. This concept opens up the use of BulletShares to small- or medium-sized pension funds or defined benefit plans to cut the cost of research and implementation.

With the future of interest rates largely being called into question, investors need to leverage every tool they can to protect capital while still generating income. Reaching outside the bounds of your typical core fixed-income fund can have many benefits.

Still, understanding the risks associated with market price fluctuation, while keeping the defined maturity to fall back on, is something many investors should take heed to.

At the time of publication, the author did not hold any of the ETFs mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Michael Fabian is managing partner and chief investment officer of Fabian Capital Management, a registered investment advisory firm specializing in exchange-traded funds.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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