[This article appears in our November 2020 issue of ETF Report.]
The U.S. 10-year Treasury yield hovered around 0.71% in early October, while the 10-year Treasury inflation protected rate was a negative 0.95%. How can a financial advisor find sufficient yields in this environment?
It’s tricky. When thinking about fixed income, not only must advisors contend with the usual aspects of duration, interest-rate and credit risk, but now they must consider potentially adding foreign exposure and possibly becoming more tactical with their positions.
How Did We Get Here?
Rob Waldner, chief fixed income strategist at Invesco, explains that colliding structural and cyclical factors are behind this stubborn environment of low rates.
A decline in inflation expectations and potential growth, along with falling productivity levels in Western countries, allowed interest rates to drop over many years.
“Those forces have driven the neutral rate down, and it’s been a multidecade process,” Waldner said.
During this time, the Fed was trying to contain inflation in the context of full employment, but its recent decision to let rates float even if inflation ticks up suggests it’s gotten inflation wrong, Waldner notes.
“They’re very serious about getting inflation up,” he explained. “So the best tool they have is to keep interest rates very, very low.”
The alternative to letting inflation pick up is “the Japanification of the U.S. economy. I think policymakers all look at that, and it scares them because it would be an extremely negative outcome for the U.S. economy,” Waldner added.
Deidre Stoken McClurg, portfolio manager for Interactive Advisors and founder of Stoken Asset Management, points out that the Fed had difficulty as it tried to raise rates in 2018, when the economy was humming along: “That’s very concerning, because at what point can we raise rates if we can’t in that [stronger] part of the cycle?”
She suggests that the heavy debt burden here and globally means only slow growth is possible for the time being: “That will change, because that’s how nature works, but we don’t know what that’s going to look like.”
COVID As A Magnifier
The impact of the coronavirus magnified all of these issues.
“Just the magnitude of the effects, the negative effects, has been dramatic, globally,” said Peter Yi, director of short-duration fixed income and head of taxable credit research for Northern Trust Asset Management, adding that no one expected this to be a multimonth, let alone a potentially multiyear, dynamic.
Although some sectors have performed well as advances in technology have helped people work from home and get more work done electronically, most sectors are still losing, he says. With companies prioritizing stability over profitability, “that’s not a great backdrop,” Yi observed.
Yi expects the Fed’s rates to remain at zero for at least five years, if not longer, pointing out it took the Fed six years to cautiously raise rates after the Global Financial Crisis. All developed-market central banks are in a similar place, he adds.
Positioning Amid Low Rates
Todd Rosenbluth, director of ETF Research at CFRA, suggests if rates remain low for the foreseeable future, investors may get rewarded for taking more interest rate risk. He points to corporate bonds such as the Vanguard Intermediate-Term Corporate Bond ETF (VCIT), with its duration of around six years.
“This is a good way of getting investment-grade exposure,” he explained. “You’re taking on a little bit of credit risk, but you’re also taking on interest rate risk and getting rewarded.”
Advisors who would rather take interest rate risk versus credit risk can look to the iShares 20+ Year Treasury Bond ETF (TLT), he notes, saying it’s a good option for credit-sensitive investors.
With equity valuations still high, McClurg uses the SPDR Gold Trust (GLD) as an equity hedge, along with other alternative assets. And she still uses Treasury ETFs, including TLT, but she also holds the iShares 1-3 Year Treasury Bond (SHY), which she calls a “good, conservative choice with a slightly higher yield than some of the longer duration U.S. Treasury ETFs.”
Muni bonds are an option, McClurg says, especially if Democrats win the White House and the Senate, suggesting that they’re more likely to flood states with stimulus. In that scenario, her choice is the iShares National Muni Bond ETF (MUB).
Consider Other Solutions
Rosenbluth points out there’s a greater case for actively managed bond ETFs, citing the PIMCO Active Bond ETF (BOND). Not only does it offer different exposures than the iShares Core U.S. Aggregate Bond ETF (AGG), which follows the Bloomberg Barclay U.S. Aggregate Bond Index, a common benchmark, but with AGG, he explains that “you’re taking on reasonable credit risk without necessarily getting rewarded.”
Additionally, Rosenbluth notes that actively managed bond ETFs can buy attractively priced debt, and choose holdings that reduce risk in certain environments.
Waldner thinks the Fed will ultimately be successful in raising inflation, but it will take time. The trend away from globalization may be one impetus. Cheap labor in the global supply chain was a deflationary force, but with global trade having peaked and likely retreating, inflation may rise a little.
Yi says that since the Fed put in place various market facilities, such as buying corporate bonds, it’s a “pretty good backdrop” for risk asset classes including equities and high yield: “Our bias right now, and one of our strongest convictions, is around high yield.”
Daniel Milan, financial advisor and managing partner at Cornerstone Financial Services, says he uses fixed income more as ballast against equities than for income, and he’ll use fixed income ETFs when he’s tactically rebalancing the portfolio: “It helps with that dollar-cost averaging, or that cost basis on the equities side.”
He’s willing to take more risk for a higher yield, finding some comfort from the Fed’s bond ETF purchases as market support. When Milan reaches for yield, he acknowledges he minds a vehicle’s duration, which will allow him some flexibility if rates rise.
Laddering & Emerging Markets
Milan is laddering target-maturity-date bond ETFs over a five-year period, specifically using the Invesco BulletShares High Yield Corporate Bond ETF series, starting with the Invesco BulletShares 2021 High Yield Corporate Bond ETF (BSJL). That laddering gives him an effective duration of less than two years, but a yield to maturity of 5.1%.
With real rates negative, Waldner observes, the value in fixed income isn’t designed to be there, noting the current situation “is designed to get you to borrow, rather than to lend.”
For investors who need stability, he notes that advisors look at diversified credit exposure that includes nondollar assets such as emerging markets.
Rosenbluth points to emerging market bond ETFs such as the iShares JP Morgan USD Emerging Markets Bond (EMB).
He cautions that investors who wade into this asset class need to consider macroeconomic risk and interest rate sensitivity of emerging market bond ETFs, and that emerging market debt isn’t the same as emerging market equities. Holdings in emerging market debt ETFs are from countries like Saudi Arabia, Russia and Qatar.
“If you consider emerging markets to be China, Taiwan and South Korea, the bond market is different,” Rosenbluth said.