Diversify Your Short Duration Income Portfolio

As financial advisors prepare for the Federal Reserve (the "Fed") to begin raising interest rates for the first time since 2006, it may be a prudent time to consider shortening the duration of their clients' fixed-income portfolios.1 Considering the relatively low yields offered by long-term bonds, an interest rate increase of 1 or 2 percentage points could result in a price decline equivalent to multiple years of income. For example, as of 8/31/15, the yield-to- maturity for the Barclays US Aggregate Bond Index was 2.4%, with a modified duration of 5.6 years.2 This implies that for every 1% increase in interest rates, the price of the index could decline by roughly 5.6%.

The difficulty with shortening duration, however, is that short-term yields for investment grade bonds are currently too low to meet the income needs of many investors. As a result, financial advisors must determine whether lessening interest rate risk while accepting more credit risk is a worthwhile tradeoff, in order to attain a more desirable level of income. For example, while the First Trust Senior Loan Fund (FTSL) bears more credit risk than the Barclays US Aggregate Bond Index by investing in a portfolio of below-investment grade floating-rate senior bank loans, the fund has minimal interest rate risk with a weighted average effective duration of 0.84 years, while offering a 30-Day SEC Yield of 4.06%.3,4

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1 Duration/Interest rate risk is a measure of a security's sensitivity to interest rate changes that reflects the change in a security's price given a change in yield.
2 Yield-to-maturity is the total return anticipated on a bond if the bond is held until the end of its lifetime.
3 As of 8/31/15. Weighted average effective duration is a measure of a bond's sensitivity to interest rate changes that reflects the change in a bond's price given a change in yield. Given that senior loans typically pay a floating rate of interest, they tend to have an effective duration of almost zero. As such, we estimate the duration for senior loans to be approximately 0.25 years.
4 As of 8/31/15. The 30-day SEC yield is calculated by dividing the net investment income per share earned during the most recent 30-day period by the maximum offering price per share on the last day of the period and includes the effects of fee waivers and expense reimbursements.

Posted on Wednesday, September 16, 2015 @ 1:46 PM

These posts were prepared by First Trust Advisors L.P., and reflect the current opinion of the authors. They are based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.