Go Tactical, Consider Active With Bonds

November 01, 2018

ETF.com: We’ve recently seen a pickup in outflows from high-yield bond ETFs. You still find them attractive as rates rise?

Menegatti: As we continue into the cycle, to your point earlier, the Fed could slow down and decide that they keep the rates lower for long and hike much more slowly. That, combined with some of the fiscal stimulus that has been put in place, keeps this economy going for longer without having a recession maybe in the next two or three years. That’s a plausible scenario.

What we've seen in the market recently has been a short-term reaction to a very quick-moving rate that essentially not only hurt whoever has taken duration exposure, but it creates concern around the timeline of the Fed.

Because the spike in rates fuels the perception of a slightly more hawkish Fed, that would essentially compress the timeline we talked about before. If that's the case, investors start taking off risk, and high yield is no exception. If one believes that we'll fall into recession in the second half of next year, then, yes, one may want to start reducing exposure to risky assets in general.

This is a personal view, and not necessarily the way we'll be positioned three months from now. I still don't think we’ll fall into a recession before 2020, and at present, sell-offs in high yield at a 3.5% spread could be a buying opportunity—that said, bear markets could show up in absence of recessionary conditions in the economy.

ETF.com: At the conference, your panel tries to answer the question: What to do if you need to earn 5% or more today? What's your main message?

Menegatti: We’re still in a low-rate environment, so it depends on the constraint of the manager. The intermediate part of the Treasury curve is attractive these days. Having some high yield in a fixed-income portfolio might still be a good idea to pick up yield as the economy still appears to be fundamentally sound.

There are asset classes at this stage of the cycle—at the frontier of fixed income—that can be a good source of yield; preferred stocks are an example. They're generally issued by financial companies that currently have good balance sheets and can benefit a little longer from the rising rate environment. We don’t seem to be going toward a credit crisis like in 2008. We may see some other type of downturn, but banks’ balance sheets seem relatively sound.

In truth, earning 5% today is a high hurdle for a fixed-income portfolio. And over the next decade, it might become a hurdle even with equities. If you go back to the early ’90s, 10-year Treasury yields were in high single digits. We're not in that environment anymore. The risk-free rate is much lower, and after adjusting for inflation, you're going to have to think more creatively if you aim to achieve a 5% yield in a fixed-income portfolio.

ETF.com: In this ongoing debate about what to do about fixed income, is there anything that gets lost in the conversation?

Menegatti: Coming out of such a low-rate environment and having interest rates going up at what potentially is a late stage in the cycle can create an environment in which equities and bonds sell off in tandem.

Investors are seeing there’s no part of their portfolio that’s really holding up at times. Their financial advisers told them bonds and equities would be uncorrelated, and that would help them mitigate losses, but the recent repricing has been widespread across asset classes.

It’s crucial here to communicate with clients about these market moves. Market repricings and corrections can be normal and healthy. These days happen to take place in an environment in which bonds and equities are moving together, and that's fairly unusual.

But I’d avoid reacting to these kinds of episodes too dramatically. Don't lose faith in diversification across asset classes even if you see positive correlation between stock and bonds. Remain diversified.

Another thing I’d say is that we've come from nearly a decade where just sitting in a passive equity index was the right thing to do. I’d encourage investors to consider staying diversified, but also to consider active managers which might be able to continue to capture opportunities, but also mitigate some of the potential downside risk that’s historically part of market behavior.

One day we might look back at the decade after the 2008 recovery and label that as an environment with unusually low volatility.

Contact Cinthia Murphy at [email protected]

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