Head of ETFs
Nuveen entered the ETF space less than a year ago. Since the launch, it has reached $170 million in assets under management, with the largest portion of that money invested in its flagship NuShares Enhanced Yield U.S. Aggregate Bond ETF (NUAG), which offers a yield-focused take on the investment-grade aggregate bond space.
Martin Kremenstein, head of ETFs at Nuveen, talks about why a plain-vanilla aggregate bond approach is simply no longer enough when it comes to fixed-income exposure.
Would you talk about the current interest rate environment and how it’s affecting bond yields?
We’re in a period where the Fed is on a tightening path and everyone knows that rates are going to continue to rise. While the market is in consensus on this, uncertainty remains around what the Fed will do to respond to market pressure. With this market dynamic, investors are starting to focus on where they have duration risk in their book.
Reviewing a fixed-income portfolio might in fact be new for many investors. Throughout the long period of the bond bull market, fixed income has been a source of stable, consistent returns and a core portion of an investor portfolio, perhaps a no-brainer for investors seeking long-term returns and saving for retirement. And this will not change. Investors must continue to have a fixed-income allocation in their books even as rates are going to go up—it’s a vital component of portfolio construction.
I think that’s all leading investors to start to reconsider how they’re getting that fixed-income exposure.
Do investors need to be more active about their bond allocations? It seems like you can’t just put your entire fixed-income allocation into a fund tracking the Barclays Aggregate anymore.
That’s absolutely right. I think it was easy just to throw it all in the Agg and into issuance-weighted benchmarks. They were the first bond index products to come out, and for good reason. Issuance weighting gives you liquidity to either hedge or execute the transaction. However, it does give you a bias towards the issuers and sectors that are the most indebted. And so, those may end up being the issuers and sectors you don’t want to have as much exposure to as rates are rising because their costs are going to go up.
The money is going into benchmark “Agg” products, which have been on a tear over the last 18 months or so, followed by intermediate bonds. There’s been a lot flowing into these portfolios, but I think investors are now starting to dig under the surface and ask, “What do we actually have here? And what do I actually own?” Because all indices are built with biases, and if you’re looking at an index product, you should be doing index research to understand those biases.
How has the bond market evolved over the years?
Compare the Agg from 2005 (pre-financial crisis), to 2017. Post-financial crisis, you saw a huge issuance of government debt due to federally funded quantitative easing. If you go back to 2005, the Agg was only 25% Treasuries. Now it’s over a third Treasuries—36%, to be precise.
You’ve also seen the corporate market expand from 20% to 26%, and the securitized market contract from 40% to 30%. The Agg isn’t in the same position as it was 12 years ago. For one thing, it’s much, much heavier on Treasuries than it was and therefore has a much greater duration-bias threat than it did before.
Investors need to consider that prices are likely not going up anymore. And whether or not prices decline dramatically is a matter of conjecture. We don’t believe yields are coming down.
Over the last 10 or 12 years of returns from the Agg, there are only two years when price return beat income return: 2011 and 2014. During a phenomenal bond bull run when yields were climbing, there were only two years when price was a bigger driver of returns than yield. If we’re entering a stage where yields are going up and price will be declining, yield is going to become even more important. When you look at factor investing in fixed income, which is where this all takes us, what’s the solution? Solutions start to break down fixed income into their component factors.
Fixed-income factors are different from equity factors, but they’re not a million miles apart. Momentum obviously exists, because anything that has a traded price can have momentum. You have value because things can be cheap. And you have low volatility, which is probably of less interest in the Agg space. Value and momentum are not particularly valuable here either. The most important factor in the Agg space is carry—which brings us back to yield.
It becomes much more important that you’re collecting as much yield as possible without taking on outsized risk. Your Agg position or your Agg-equivalent position is very much a safety position. If you want risk, you buy equities or high-yield bonds; you don’t buy the Agg.
But it’s really about looking to enhance carry and yield within the portfolio without taking on outsized risk.
How can an investor construct a portfolio that has sufficient yield at a reasonable risk level?
First of all, investors should look at how much Treasury exposure they really want to maintain. Do you want that much government debt, or are you going to start to move towards spread product such as corporates? Or if you want to have an aggregate bond position, you look at aggregate bond products that increase your exposure to spread without taking on excess duration.
And so, we built two products that do that. The first, the NuShares Enhanced Yield U.S. Aggregate Bond ETF (NUAG), is in the intermediate space, and then there’s the Nu-Shares Enhanced Yield 1-5 Year U.S. Aggregate Bond ETF (NUSA). They’re both designed to be alternatives to their equivalent-duration aggregate bond competitors. However, the funds are tweaking the exposure by asset class, sector, duration bucket and credit bucket to tilt the portfolio more towards yield.
You can do that really by first dividing up the aggregate bond universe into 35 component parts. First, when you look at the asset classes, you’ve got Treasuries, you’ve got agencies, you’ve got corporates and you’ve got asset-backed securities. Corporates are further divided between the industrial, utility and financial sectors.
Then we divide up into the one- to five-year, five- to 10-year and the 10-plus-year duration buckets. Obviously, this is for NUAG; NUSA is concentrated entirely in the one- to five-year bucket. And then within each of these buckets, we look at the credit ratings: the AAA, AA, A and BBB. Each of these 35 buckets is assigned an effective risk rating that tells us how much you can under- or overweight that bucket.