Using maturity-targeted ETFs to manage curve exposure

Using maturity-targeted ETFs to manage curve exposure

Income investors typically use ETFs to provide low-cost access to the returns of their chosen markets, whether that be broad exposure or a more precise segment of the market. They are often looking to achieve a yield-related objective, for example delivering a target yield relative to cash or inflation, or wanting to manage their credit, currency, duration or any other risks inherent with the asset class. Here, we look at how maturity-targeted ETFs can help investors manage exposure to the yield curve.

The yield curve charts the yields of securities, e.g., US Treasuries, with different maturities at a specific date. It typically moves with changes in interest rates and expectations for future rate movements. Higher rate expectations normally drive up the yields of short-dated bonds by more than those of longer-dated bonds, and vice versa when the market expects rate cuts. Often, however, you will find pockets along the curve where particular maturities appear either expensive or cheap relative to securities around them on the curve. These situations can present opportunities for ETF investors. 

Recent movements in the yield curve

After more than a year of aggressive policy tightening, we agree with the consensus belief that interest rates in most major developed economies are at or very near their peak in this cycle. The Fed has warned markets that it expects interest rates to remain “higher for longer”. This outlook is being priced into interest rate futures, but the 25-50 basis points of cuts the market expects in 2024 suggests investors predict a soft landing, presumably where inflation continues to ease without the impact of previous rate hikes crushing economic growth. The US Treasury yield curve, however, is telling a different story. The 10y-2y yield curve is inverted, meaning the 2-year yield is higher than the 10-year yield, which historically has been a precursor to recession in the next 12-24 months. (Note: it’s been inverted since July 2022.)

ETF flow data also indicates a more cautious investor, given the marked increase in demand for government bonds and lack of appetite for riskier bond assets over the past year. Flows into US Treasuries, Euro government bonds and UK Gilts, along with cash management exposures, accounted for almost the entire amount into fixed income ETFs in Q3. Perhaps more interesting are the parts of these asset classes that are gaining most attention. Many investors started increasing duration in Q2, first primarily into the 7-10 year range and then, especially in Q3, into the 10+ year bucket. 

Looking at the yield curve, we saw the 10-year Treasury hit new cycle highs early in October after stronger-than-expected employment data out of the US, but interestingly the sell-off ran out of steam, possibly an indication that many investors are calling this the top and looking for opportunities to buy into weakness.
 

Using maturity-targeted ETFs to manage curve exposure

Maturity-targeted ETFs aim to capture the performance of bonds within a specific range of maturities. Investors can use these ETFs to tailor their exposure more precisely to their objectives and to express their views on markets, the economy, yields, etc. 

An investor might select the ETF offering a profile closest to their requirements or, alternatively, combine ETFs for an even closer match. Let’s say you want to maximise yield with a duration target of 6 years. There are fairly straightforward options available. For instance, you could combine ETFs offering exposure to the 3-7 year and 7-10 year buckets, which may satisfy your duration target but fall short on yield. Alternatively, you could include the higher-yielding short-dated (1-3 year) ETF in a proportion that meets both objectives more effectively.

Along similar lines, we have seen some investors adopt a barbell approach in recent months. This strategy involves investments in both the longer end of the curve (to increase duration) and the shorter end of the curve (to increase yield and partially balance the longer duration exposure). If you are considering an ETF targeting the 7-10 year bucket, which is currently the lowest-yielding maturity range, you could instead invest in the 1-3 year ETF and 10+ year ETF in relatively equal proportion. The profile would leave you with a similar duration as the 7-10 year bucket but with a meaningful improvement in yield.
 

Positioning depends on your outlook

Choosing which maturities to target may be partially guided by your need for yield but is likely to be more heavily influenced by your outlook on future rates, which depends on several factors including, perhaps most importantly, the progression of inflation. Whatever your view is, you’ll find an ETF – or possibly a combination of ETFs – that could help you position accordingly.