Risk Looms Large In Most Popular Bond Index

January 30, 2018

Jeffrey ShermanJeffrey Sherman is deputy chief investment officer at DoubleLine. In that role, he has unique insight into the fixed-income market. Here Sherman offers a glimpse into what advisors and investors are faced with when it comes to bond investing this year. He’s also part of the team managing the SPDR DoubleLine Total Return Tactical ETF (TOTL), an actively managed intermediate-term bond fund that goes head to head with strategies tracking the Bloomberg Barclays U.S. Aggregate Bond Index. TOTL currently takes some 30% less duration risk than the index for a yield that’s roughly 100 basis points higher at about 3.6%.

ETF.com: Is an inverted yield curve something you see ahead in 2018?

Jeffrey Sherman: It's been very popular to discuss the flattening of the yield curve, which does not portend inversion, but it tends to put people on alert. There’s a very small term premium between the two-year/10-year Treasuries. But it does not signal recession.

What you're seeing is that the front end of the curve is pricing in tax cuts, which could be stimulative from an earnings perspective. We have been running with a three-handle [3%] annualized GDP rate in the last couple of quarters, so the market is thinking there’s been growth in the U.S. economy. There're also some signs of some inflationary pressure.

But the back end of the yield curve doesn't seem to be buying it, so, two different outlooks.

The two-year/10-year spread isn’t signaling a recession's imminent, but perhaps that there’s a higher prospect of short-term growth. And the back end of the curve is saying this isn’t going to be all rosy longer term. It’s a bit a conundrum how the 10-year hasn't repriced these big fiscal deficits, which is inherently structurally bad for the Treasury market over time.

ETF.com: From an advisor perspective, is the bigger challenge making sense of what the yield curve is really signaling?

Sherman: You have the setup where you have positive GDP growth in most of the developed world, and in a lot of the emerging world, too. There could be a little bit more inflation in the market; the commodities market's been signaling that. And if the bond markets start to really buy into this idea that growth will be here for a prolonged period of time, yields need to go higher, and the Fed is trying to push that.

The question becomes, in a higher-yield environment, do risk assets look as attractive as they do today? Spreads are tight when you talk about the bond market because people have been buying for yield, and they've driven this spread premium down significantly. Just because everything is going up doesn't mean you're going to win by buying risk assets in the bond market if indeed rates push higher.

You have to be careful. You have to manage the duration of your bond portfolio. The Agg [Bloomberg Barclays U.S. Aggregate Bond Index] is extremely long right now; it's near some of the longest it's ever been in terms of the interest rate sensitivity at around six years. And there's not a lot of spread cushion or a lot of yield to help offset that price loss if yields go up.

You need some protection in case there is a policy misstep. It's a challenge right now in the bond market because spreads are tight. Yields look like they should press up somewhat, at least in the short to medium term. And if inflation ever steps back in, you could see the bond markets reprice very quickly.

ETF.com: We’re seeing a lot of asset flows into funds like the iShares Core U.S. Aggregate Bond ETF (AGG), but are investors buying into midterm bond funds with duration near all-time highs and yields near all-time lows?

Sherman: We designed TOTL to be an intermediate-term bond ETF, but we wanted to have an attractive yield-to-duration ratio. You can't just sit there and manage yields and just blindly buy. You have to think about risks. Thematically, 2017 will be characterized by a period of extremely low volatility in the market. When you look at the volatility of TOTL, it's been less than the Agg index. We had comparable returns to it net of fees last year because we're not into outsized risk-taking at this stage of the market. The idea is to manage the duration. It's also to manage the credit risk in the portfolio.

Our focus right now is on the fact that the Fed is not only raising rates, they're allowing some of the assets of their balance sheet to roll off. Those bonds have to be gobbled up by investors, not the Fed. And the ECB [European Central Bank] is also not buying as many bonds, so all these extra bonds have to clear the marketplace. There’ll be more supply.

Don't forget that we just passed the tax cuts in last couple weeks that are going to increase the supply of Treasuries. They have to do that because we're going to have less revenue coming in to keep the budget where it is. So the Fed is going to introduce roughly $280 billion in bonds this year. The ECB is going to buy 30 billion euros less for the next nine months. That's 270 billion more euros, so that's about another $320 billion. And that doesn't include the tax cuts.

There’s a lot going on, as you can tell. But investors have been somewhat complacent, looking at the Fed, which has laid out the path. But you have to remember that even the Fed leaders are changing. People shouldn’t assume it’s going to be more of the same.

In the low-vol environment we’ve had, people get lulled into complacency. They don't realize that as yields stay steady or as the prices of bonds go up, to get that same yield, you have to take more risk.

It's not the time to be upping risk, it's the time to be managing it and perhaps thinking about ways to take a little bit more risk off the table.

Contact Cinthia Murphy at [email protected]

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