ETF.com: In this environment of plunging Treasury yields and uncertainty about the global economy, how do corporate bonds fare?
Smith: The U.S. corporate bond market is now more than twice the size and about 50% more leveraged than it was in 2007. When looking at total debt to GDP, the U.S. is about 250% leveraged to its economic output. This is a troubling trend in view of the global economic slowdown that’s emerging and the already historically low interest rates that exist worldwide.
It’s also important to keep in mind that slightly more than 50% of the investment-grade corporate bond market, or $3 trillion worth, is rated in the Baa/BBB category. We estimate half of the Baa/BBB rated bonds lie in the bottom half of the category, only a few notches away from junk status.
This is troubling when one considers that there’s already about $1 trillion of junk bonds outstanding. A significant increase in this amount due to rating downgrades and migration from the investment-grade sector are a growing concern for many market participants.
We’re suspicious of the higher leverage levels that are being carried by many nonfinancial companies in this economic environment, and as such, are looking to selectively reduce exposure to high credit beta positions.
Flanagan: If things ratchet up on the risk-off side, high yield spreads would underperform. Investment-grade spreads can widen, but they’re going to be more interest rate sensitive than high yield, so they could actually outperform high yield if we have a risk-off environment.
But on the flip side, what if cooler heads prevail in the trade war? Then more than likely, any widening in high yield spreads might be a buying opportunity.
ETF.com: How should investors position their fixed income portfolios? What types of segments should they overweight/underweight, and what types of ETFs should they buy?
Flanagan: We’ve been suggesting investors take a look at the barbell strategy. Think of it like the weight lifting device where you have a weight on each end of the actual barbell.
On one end, we would focus on our yield-enhanced strategy, the WisdomTree Enhanced U.S. Aggregate Bond Fund (AGGY). On the other end, we would focus on the Treasury floating rate strategy, the WisdomTree Floating Rate Treasury Fund (USFR). What’s nice about this is that you can toggle the weights back and forth between the two funds.
With these, you’re not making a big conviction bet on where rates are going to go. If you feel rates can continue to move lower and you’re looking for a little total return and some income, you have the yield-enhanced AGGY on one end.
But if the Fed disappoints and rates stay flat or move back up, then the floating rate mechanism of USFR would come into play and help mitigate some of that risk.
Smith: Given the current fixed income market environment, we think investors should be biased to longer-duration, high quality fixed income investments (e.g., long-term investment-grade corporates and Treasuries).
We’re underweighting high yield and emerging market debt as well as low quality investment-grade credit risk given the poor financial fundamentals and near-term technical factors that surround these sectors at this time.
We think that, while the mortgage-backed securities market suffered a recent short but sharp price adjustment due to the drop in interest rates, this has settled out, and the sector is now worth considering for those seeking a more stable, high quality liquid alternative to fully valued corporates or lower-yielding Treasuries.
Given the economic backdrop, it’s difficult to justify a position in inflation-protected securities or securities leveraged to an expectation for higher interest rates in the near to intermediate term.
If the rate environment continues to decline, we suspect that ultra-short-duration fixed income and money market funds or ETFs will come under pressure to retain assets. International non-U.S. fixed income ETFs will also likely come under pressure the longer negative rates persist in the major EU and Japanese markets.