DFCF ETF: A risky bet in a ‘longer-term higher’ interest rate environment | Private Equity Weekly

Dimension Core Fixed Income ETF (NYSE:DFCF) is a great way to participate in the global investment grade bond market.Benchmarked against the Bloomberg Aggregate Bond Index (Bloomberg Agg) or the Bloomberg U.S. Aggregate Bond Index, DFCF offers investments in long-term bonds and other fixed income securities that, overall, are expected to to maximize investors’ total returns. While the current high interest rate environment may not be a good time to invest in long-term bonds, there are some advantages to this strategy. But for now, that’s a reservation for me. The analysis below will tell you why.

The yield curve inversion and what it means for bond investors

The current yield curve has been inverted for some time.This means that short-term bond yields are higher than long-term bonds, as shown in the chart above (blue line) and the table below obsolete March 1, 2024.

Since the federal funds effective rate is about to exceed 4%, the current inversion has lasted for nearly a year and a half (The following table).

A closer look at the second table above (November 2022) shows that the flattening and subsequent inversion of the yield curve has been swift and decisive, largely due to the fact that the Fed has accelerated the pace of rate hikes to 75 base point. Then.Compare the above table with The one below You can see why this reversal happened so quickly.

The Fed continued to raise interest rates in the following quarters, and by the time it implemented its last 25-basis-point rate hike in July 2023, short-term bond rates were already above 5.4% and in line with the federal funds rate (July/2023 See the table above for bond yields in August.)

As of today, the federal funds rate remains high at 5.33% and yields on short-term bonds currently range from 4.94% (1-year) to 5.54% (1-month), so why invest in longer duration ETFs with higher yields? Low?

You can find the answer in the difference in the sensitivity of short-term and long-term bond prices to interest rates. Please note that we are not talking about bond yields here, but bond prices. This sensitivity essentially means that long-term bonds are more sensitive to rising and falling interest rates.this PIMCO’s form The chart below shows how long-term bond net worth is exponentially affected by changes in interest rates.

That could make DFCF an attractive proposition right now, at least for investors who think interest rates are about to fall this year. However, I don’t think this will happen anytime soon, as we will see in the next two sections.

DFCF background

The value of the ETF lies in how the fund manager allocates funds within its portfolio. Generally, the fund invests in fixed income securities with durations of 20 years or less and ranges around a benchmark average duration on a weighted basis.As of Last annual report The benchmark’s weighted average duration for the period ending October 31, 2023 was 6.04 years, compared with 6.63 years a year ago. Ideally, the ETF’s range should not be one year or four years shorter than the benchmark duration. one part. In terms of actual duration, DFCF’s average duration was 6.15 years, down from 6.63 years in the same period last year.

Notably, this period (October 31, 2022 to October 31, 2023) is characterized by a flat to inverted yield curve that favors short- and medium-term bonds. Under normal yield curve conditions, the ETF would be more invested in bonds with longer maturities, but the reality of the yield curve over that period means completely stripping out any bonds older than 20 years and increasing their exposure to one-year or one-year maturities. Positions in short-term securities are of shorter duration. If the fund manager did not do this, the total return on a relative basis would be lower than the benchmark; however, due to the fund’s dynamic allocation strategy, this is avoided and the ETF performs relatively better than other strategies.

In particular, the fund shifts investments toward corporate bonds rated A or BBB as credit premiums are higher due to wider spreads. Essentially, a credit spread in bond parlance is the difference in yields between two different debt instruments with different credit qualities but the same maturity or duration. Therefore, when spreads are wide, it is prudent to allocate funds to high-quality securities but also put money into lower-grade baskets to capture more credit risk.

That’s what fund managers did, and the move was validated by ETFs reporting positive realized credit premiums throughout the reporting period as a result of this tactical shift.In contrast, the benchmark only returns 0.36%thereby verifying whether this strategy change is suitable for the inversion of the yield curve.

Moving forward with DFCF

The key to the investment theme here is whether you believe the Fed will start cutting interest rates this year, and by how much. As we can see, the fund’s current bias toward short-term fixed-income securities plays out in a “longer-term higher” interest rate environment, but only barely compared to the benchmark. The fund’s strategy can only reach its full potential when the yield curve is normal, which is why your view on the Fed’s actions this year is so important.

Looking at macro factors, especially CPI, we see that this key indicator continues to remain above 3%; in other words, consumer price index It has been oscillating between 3% and 3.7% since June 2023, and does not seem to want to match the market’s hopes for a rate cut by the Federal Reserve in 2024.

In fact, as long as two days agoTorsten Sløk, chief economist at Apollo Global Management, made his view on what will happen very clear:

The reality is that the U.S. economy is not slowing down at all, and the Fed’s pivot since December has provided a strong boost to growth. Therefore, the Federal Reserve will not cut interest rates this year, and interest rates will remain at a higher level for a longer period of time. Growth expectations for 2024 jumped sharply following the December Fed pivot and related easing of financial conditions. Growth expectations for the United States continue to rise. After the Federal Reserve turned around in December, financial conditions continued to ease, investment grade bond issuance hit a record high, high-yield bond issuance was high, IPO activity increased, M&A activity increased, credit spreads narrowed, and the stock market hit a record high. With financial conditions easing significantly, it’s no surprise that nonfarm payrolls and inflation were strong in January, and we should expect this strength to continue.

The takeaway is that market expectations may not materialize this year because the economy is expected to continue growing strongly despite rising interest rates.

Returning to the DFCF investment case, the fund seems unable to return to its original strategy anytime soon. Their portfolios must weigh their average duration at the lower end of the benchmark range, which, as we have seen, has moved lower during the reporting period.

In this case, the fund will have to continue to shift its tactical strategy toward short-term securities. Unfortunately, while this may beat the benchmark, the goal of superior total returns is much more elusive. This must continue as long as yields reverse. This is the main drawback here.

Another risk now is that the longer credit spreads remain wide, the more likely funds will gravitate towards lower-grade securities with higher yields – for investors looking for safe investment vehicles for their fixed-income needs. This is not an ideal situation because the rating of the security equates to greater credit risk. This could cause serious problems if the economy goes into recession, but it’s not entirely impossible yet. There are different opinions on this, so I think it’s best to err on the side of caution.

At this point, no one knows what actions the Fed might take this year. They seemed to have pivoted towards the end of last year to keep rates steady, but when will they pivot to lower rates? No one knows for sure, and that’s the risk of investing in DFCF.

Conversely, if a rate cut materializes over the next ten months, it could provide fertile ground for the fund’s strategy to work to its advantage. Currently, the market and the overall economy are strengthening, although inflation remains stubbornly above 3%, making it very difficult for the Federal Reserve to cut interest rates. Ideally, inflation and economic activity should slow before the Fed shifts its focus from the current QE policy to the QE phase, but we don’t think that will happen this year.

This makes DFCF’s risk-reward profile highly skewed toward risk over reward, which is why I can’t recommend a buy, even though I like the core strategy here. However, I wouldn’t rate it a Sell because if you’re already involved, you might want to bite the bullet and wait for it to be over. Hopefully, your DFCF position is far from one of your largest holdings; if so, you may want to exclude some of the notional gains from beating the benchmark (as opposed to beating the market) and reduce your exposure to the ETF. Furthermore, if you’re really bullish that the Fed is going to cut rates over the next year or year and a half, despite all signs pointing to the contrary, there’s no need to even do that. Therefore, I am currently holding on to this interesting trend in the global investment grade bond market.