The Treasury market has understandably had a lot to grapple with this year.  Price action has been dictated by the increasing threat of a hike in short-term interest rates or the subsequent hangover from commodity and currency volatility.  The real question that remains, as individual and institutional investors alike position themselves along the yield curve – are long dated Treasuries going to rally on the news of a rate hike or could we see a repeat of 2013?

I’m inclined to believe that longer dated Treasury holders are going to love a rate increase, and that we could see the yield curve ultimately invert.  This is essentially a phenomenon where prices of long dated securities rise and short dated securities fall, causing the yield curve’s shape to double back on itself.  The net effect is a downward slope rather than upward.  This happens as a result of deflationary pressure on short-term borrowing costs, since the Federal Reserve is acting in response to what should be an overheating economy and not their alternative mandate of counteracting inflation.

The problem for income investors is that we could experience a credit market climate that isn’t conducive to widespread risk taking.   This comes as a result of one of the primary fundamental goals of Fed policy coming full circle: investors simply won’t be persuaded to assume more risk for more yield.  Instead, they should fear risk asset volatility, and presumably look to profit from the inevitable flight to quality and subsequent fall in long-term interest rates.

But with so many balls in the air, how should investors change their fixed-income holdings now to avoid getting stuck in the inevitable volatility?

I wish I could tell you now is a good day to sell your junk bonds and buy long-dated treasuries with the proceeds.  However, with the recent volatility and established trends, the answer isn’t that simple.  Instead, investors should remain vigilant in monitoring the Fed for changes to short-term interest rate policy.

When a change does happen, it would likely behoove you to overweight your portfolio toward core fixed-income funds such as the PIMCO Total Return ETF (BOND) or DoubleLine Total Return Tactical ETF (TOTL).  Consequently, you should avoid funds such as the iShares High Yield Corporate Bond Fund (HYG) or SPDR Barclays High Yield Bond ETF (JNK).

I prefer the ETF options BOND and TOTL over indexed options such as the iShares U.S. Core Bond ETF (AGG) or the Vanguard Total Bond Market ETF (BND) because if there were ever a time in recent memory when you should pay for active management, now would be that time.  A tricky sector, interest rate, and Fed policy environment could prove to be full of pitfalls.  As a result, paying an extra 0.10-0.30% in expense ratio will be well worth the price of admission. Furthermore, each manager can also offer their unique allocation and portfolio yield curve positioning themes above and beyond your individual portfolio asset allocation.

I think that the current environment represents a “calm-before-the-storm” mentality, despite Treasury rates largely backing up over the last four weeks from the low they established earlier on in the year.  Furthermore, although we are not forecasting a significant rise in the 10-year Treasury rate, I wouldn’t get cavalier by adding duration at current levels like we did for our Strategic Income Portfolio back in the 4th quarter of 2014. The risk just simply doesn’t align with the return potential, unless we undergo a more prolonged equity correction.

The prior 12 months have been good to fixed-income investors.  Nevertheless, the next 12 months will probably not be so easy.  So from a strategic perspective, knowing your fixed-income sector allocation, duration, and credit quality exposure will prove key in making decisions over the coming year.  As always, we will seek to allocate our client’s assets to themes that present the lowest volatility and highest income given the risk/reward profile in the market.