How To Approach Today’s Bond Market

April 18, 2019

Tim Urbanowicz

With fear of slowing economic growth and the Fed's shifting stance on rates, the bond market is certainly keeping investors on their toes, says Tim Urbanowicz, senior fixed income ETF strategist for Invesco.

Recently Urbanowicz shared with his 30,000 ft. view of the bond ETF market, including what he sees as today's biggest risks, how many bonds investors need in their portfolio to be truly diversified, and what he sees as the next leg of growth for smart-beta bond ETFs. What trends in the fixed income market right now do investors most need to be aware of?

Tim Urbanowicz: Well, 2019 has been a good year for bond investors across the board. Both investment-grade and high-yield corporates are off to their strongest start in many, many years. But rates also have come down fairly significantly, now that the 10-year [Treasury yield] is at about 2.5%. Along with that, we've seen strong compression in credit spreads.

So going forward, the challenge now is that we're in a very-low-rate environment again. Lots of focus is on the Fed. Until early January, they were almost on autopilot with tightening, but now all of a sudden they've come out to say they're going to be patient [on more interest rate hikes]. [Fed Chairman Jerome] Powell has stated their No. 1 goal is to keep expansion going as long as possible.

With that, you’ve seen the rate conversation, which was a focus last year, diminish. There's a lot of fear that we're heading into the late stages of the cycle.

Also, corporate leverage has grown significantly over the years; from precrisis to now, the amount of corporate debt has gone from just over $3 trillion to almost $7.5 trillion. You also have concerns over the size and growth of the BBB [debt] market, which now represents over 2.5 times the size of the entire high-yield market. Given those issues, should investors be concerned about putting their money into corporates or bonds rated BBB?

Urbanowicz: You just need to be more thoughtful about how you piece together your allocations now than the traditional, "Let's just add credit risk and duration to our portfolios" [mindset] that worked so well post-financial crisis.

Yes, the amount of debt has grown. But when you look at leverage ratios, those metrics have been held in check, because we've seen such strong growth and consistency in the top line. Earnings have been strong, which has supported the growth in debt.

The biggest risk I see to the market right now is if you see this earnings growth end. If you see trade uncertainty, weaker economic growth or even rising wages start to impact earnings, you could see a potential crack.

On the flip side, looking at BBBs, areas like that potentially are the more attractive. A lot of the fear around that market has kept spreads fairly robust relative to other pockets like A or even BB [bonds]. Right now, you have a lot of investment-grade BBBs out-yielding high-yield BBs, simply because you have a lot of investor fear. Then how should investors adjust the diversification of their fixed income portfolios, if at all?

Urbanowicz: Investors need the diversification. Bonds aren't like equities; you can have maybe 20 or 30 stocks and fully diversify away your single-security risk, because you might have one equity that goes to zero while another one doubles in price and offsets that.

That's not the case with bonds. With fixed income, if you do have a bond default, there's not another bond in your portfolio that'll bail you out from that. With bonds, your best-case scenario is that the issuer makes their coupon payments on time, and you get your par value back at maturity.

Many individuals don't buy enough bonds to truly diversify away that credit risk. From that standpoint, you'd probably need about 70 bonds to be truly diversified. That's a lot of bonds. Most individuals, unless they have $10 million or $20 million, aren't going to be able to diversify that risk away by just buying individual bonds. That's where the ETF structure can be so powerful.

At the same time, many ETF indexes or active managers are managing their portfolio to a set duration. And there's nothing wrong with that. But historically, when you see volatility in interest rates or credit spread, those two factors tend to have a higher explanatory power over your future return stream than your starting yield does.

One of the areas in which we've seen almost 50% growth in ETF assets over the past year is in defined maturity spectrum funds, like the [Invesco] BulletShares suite of ETFs.

Unlike a traditional bond ETF, where you have index rules that sell bonds before maturity, the BulletShares ETFs buy and hold bonds through final maturity. You're not managing to a set duration. At the end of the day, you can more precisely target the risk you're taking on, versus traditional funds or ETFs.

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