Of all the problems investors face in 2018, deciding what to do with their bond portfolios is one of the biggest. On Jan. 23, the Inside ETFs conference will feature five of the world’s leading bond ETF experts discussing exactly what financial advisors should do in the year ahead. In anticipation, Inside ETFs CEO Matt Hougan recently spoke with Guggenheim’s Bill Costigan, Director, Fixed Income Portfolio Management, about what investors should do. The answers were surprising.
Matt Hougan: You’re coming down to Florida to speak on our “Fixing Income: Bond ETFs, Active Strategies and Portfolios for Rising Rates” panel. My first question is: What should investors be thinking about in their bond portfolios as we enter 2018, and why?
Bill Costigan: A benign credit environment and low interest rates have encouraged some investors to reach for yield by increasing credit risk and/or duration risk. This underestimates the risks posed, particularly as U.S. monetary policy tightens.
Today’s market is marked by low volatility and tight credit spreads. Many investors have become complacent. Resultantly, the credit curve has compressed significantly, thus offering investors diminished risk-adjusted return in high yield bonds, for example.
Our firm view is the Fed is likely to hike four times in 2018. That means managing interest rate risk—specifically key rate duration positioning—is paramount.
MH: That sounds challenging.
BC: We think of it as an opportunity. It gives advisors a chance to add value for their clients by finding the right manager.
Index investing has been an incredibly important development, particularly in the U.S. equity markets. But the opposite has been true of fixed income. Over the past five years, the average active bond manager has outperformed its benchmark. We think this trend will persist, especially in the current environment marked by low yields, rising rates and heedless risk-taking.
MH: Why do you think managers are more effective in bonds than stocks?
BC: When you look at the fixed-income landscape, it’s roughly $40 trillion, but less than half of that space is captured in the marque benchmark, Bloomberg Barclays Aggregate Index. So as a manager, you have a big space to play in, coupled with a high degree of inefficiency. That vastness and complexity have enabled top managers to consistently outperform their benchmark.
For example, commercial asset-backed securities and investment-grade collateralized loan obligations, which can offer comparable (or higher) yields and lower durations than similarly rated corporate bonds, have generally been excluded from the index.
Currently, the Bloomberg Barclays U.S. Aggregate Bond Index is dominated by low-yielding, government-related securities. I’m not sure that you want to overweight those securities in a period where the Fed is beginning to unwind its treasury and agency mortgage-backed holdings.
MH: OK, but how does an advisor choose? There are a lot of active managers out there and a lot of them sound smart. How are they supposed to find the right one?
BC: I would look for managers with a consistent track record and an investment process that is predictable, repeatable and scalable.
MH: The starting point for any active manager is their macro forecast. What does your macro team see for the economy in the year ahead?
BC: Our recession forecast is late 2019 or early 2020. We think we could see four hikes from the Federal Reserve in 2018. The big question mark outstanding is probably the inflation number, and obviously inflation has been low relative to expectations. We think the yield curve is going to continue to bear-flatten in 2018, with the front-end rates moving higher and the long end likely capped around 3 percent.
MH: Why is the long end capped?
BC: It’s a function of long-term inflation expectations being low and there being strong international demand for the long end of the U.S. fixed-income curve. Foreign capital has been fleeing to the U.S. as foreign corporate yields remain historically low. Foreign investors are likely to represent a large share of overall demand over the next few years as foreign central banks maintain accommodative monetary policies.
MH: What does all that mean for the portfolio?
BC: Our flagship Total Return Bond Fund (GIBIX) is positioned in a barbell. Roughly 70 percent of the portfolio is in floating-rate bonds, and the balance is at the long end of the curve. We’re trying to avoid the belly of the curve—the two- to seven-year segment—that we think is vulnerable to repricing. Our Guggenheim Total Return Bond ETF (GTO) is similar to the mutual fund—offering a more diversified multi-sector approach than traditional core fixed-income choices.
MH: How would someone use your Total Return mutual fund or GTO ETF in their portfolio? Is it a wholesale replacement of their core Aggregate Bond exposure or does it layer in on the edges?
BC: Both can be a wholesale replacement for the client. While the underlying securities are different from the Aggregate, many of the high-level characteristics are similar. And there are guidelines in place to prevent, say, investing too heavily in below-investment-grade credits.
Many people who know bonds believe that the Agg is the last place they would put their own money. Given the overweight in Treasurys and the massive quantitative easing that’s gone on, it’s really more skewed to government and agencies than it was even 10 years ago before the financial crisis, and possibly too skewed for most investors.
MH: Do you think investors should be rethinking their overall allocation to fixed income in their portfolios?
BC: No. With the stock market setting 70+ record highs last year, now is not the time to abandon fixed income, which has acted as a ballast during stock market corrections.
One popular argument is that people might consider high-dividend-paying stocks as a replacement for bonds. But what happens, for instance, when a company like GE massively cuts its dividends and the stock price falls? We’ve had such a bull market in equities and such a low-volatility run-up in the S&P 500 that it’s very easy to become complacent.
In credit markets, such as high-yield corporate bonds, I think investors will look back with regret at how much risk they were willing to take for such little compensation.
MH: What else can investors do in this market to prepare for rising interest rates?
BC: In addition to rethinking core fixed-income strategies, one of the most effective ways to manage changing interest rates is through bond ladders. A ladder strategy helps address some of the risks inherent in this uncertainty by holding bonds until they mature and then reinvesting proceeds in at then-current yields further out on the ladder. Historical analysis of laddering from Crestmont Research shows bond ladders have never had a negative return in a five-, seven- or 10-year period. However, laddering with individual bonds can be challenging … researching the bond, sourcing bonds and just the amount of money needed to build a ladder. That’s why Guggenheim launched BulletShares ETFs. Using BulletShares for bond laddering is one of the most common ways we see advisors employ BulletShares.
MH: Let me close with this: Let’s say you had 30 seconds to give the financial advisors at my conference a piece of parting wisdom about their bond exposure entering 2018. What would that be?
BC: Don't look at the average duration of your portfolio; it can be misleading. You need to evaluate the key rate duration. How much is in floating-rate credit, how much is in intermediary exposure, how much is in the long end?
We’ve seen a lot of people abandoning the long bond because they were worried about Fed hikes, and pile into shorter-term securities. Last quarter (4Q2017), this strategy would have been problematic as two-year treasury notes spiked nearly 30 percent (1.89 percent at 12/29/2017 from 1.45 percent at 9/28/2017), while 30-year treasury bonds rallied to 2.74 percent from 2.87 percent. It’s not necessarily about reducing duration in a rising rate environment; it’s about effectively managing it.
Matt Hougan is the CEO of Inside ETFs. Inside ETFs and Wealthmanagement.com are both owned by Informa, PLC.