Sage is the world’s leading fixed-income ETF strategist. Based in Austin, Texas, it’s made a name for itself by offering institutional-grade insights and portfolios that consistently stay one step ahead of where fixed income is going.
That’s one of the reasons Bob Smith, co-founder of Sage, is speaking at Inside Fixed Income, the world’s leading bond ETF conference, taking place Nov. 2-3 in Newport Beach, California. He sat down recently with Inside ETFs to discuss what he plans to talk about at the conference, and where he sees risks and opportunities in the ETF market.
Inside ETFs: With the 35-year decline in interest rates seemingly over, should investors even own bonds in today's market?
Bob Smith: The answer is yes. The question is, for what purpose? I think in every investment, one has to see the utility that an investor needs for their life style.
Clearly, for anybody who has a cash flow sensitivity, or the need for principal at a particular date in terms of fulfilling a certain funding or a certain drawdown, fixed income is a far more predictable and less volatile asset class compared to anything in the equity spectrum or any of the alternatives. It offers peace of mind for those who really want some predictability in terms of outcomes and reaching their goals.
Inside ETFs: But should investors hold fewer bonds in their portfolios than they did in the era of falling rates?
Smith: If you look at it purely from a total return perspective, one would argue that we probably are in a basing or bottoming of this particular cycle … although I think the jury is still out.
If you look at 10-year Treasurys, there are those who would forecast rates going somewhere to about 2.75-3% or beyond. And then there are those that feel the economy has had virtually no growth.
You look at the money supply and you look at the still-declining velocity or turnover of that money supply—it's highly suggestive of an economy that's not really growing much beyond the 2%-plus trajectory we've been stuck in for many years.
We're still in a trading range. And in this environment, I think it's probably worthwhile to hold a good position in high-quality investment-grade securities. Bonds are not as attractive as when they were at 5% and 4% coupons, but in today's world, we're not going all the way back to 4% or 5% quickly. Therefore, it's more of a hold than it would be a buy at this point.
Inside ETFs: What are you hearing from your clients about the market? What are they worried about? And what are you telling them?
Smith: We are basically overweight investment-grade credit. We have reduced and really brought down our exposure to high yield. We have reduced and eliminated our exposure to bank loans. We have a small position in preferred stocks.
We're starting to roll up, if you will, our credit exposure, and we're starting to get more concerned about not getting paid as well as we used to get paid for some of that risk.
We think it's time for people to be perhaps a little bit more conservative, and doing so in the ETF market is pretty easy. Rolling out of the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) or the SDPR Bloomberg Barclays High Yield Bond ETF (JNK) and down into the PIMCO 0-5 Year High Yield Corporate Bond Index ETF (HYS) and coming down the curve is also something we've been doing.
While we've been reducing credit risk, we've also been somewhat moderating our duration exposure and being more careful about the fact that rates may start to trend a little bit higher here, although not significantly.
Our sense is, if you're not getting paid for the risk, don't take it. In this environment, we're leaning harder on more core positions, more high-quality positions, not eliminating credit risk in totality, but preferring more investment grade as opposed to high yield.
Inside ETFs: Let’s get a bit broader here. Outside of the bond market, are there specific things keeping you up at night?
Smith: Things that keep us awake at night as risk managers, clearly, include questions like: What’s going to be the environment in regard to central bank policy?
Clearly, there's a shift that is afoot in terms of trying to eliminate the vestiges of QE on more of a predetermined and continual basis. Chairman Yellen clearly has indicated they’re going to be consolidating the balance sheet of the Fed, which has expanded dramatically over the various different QE initiatives. So how and when and to what degree that happens, that’s what we worry about at this point.
Secondly, those who drive that policy may not be in that chair for very long, because the new administration will have the ability to replace the Fed chairman and a significant number of votes on the Board of Federal Governors. So there's a lot of change that may come from a political perspective that will make its way into the consciousness of the market as we roll down through the year.
Clearly, what's going on with the ECB and with the Japanese central bank is also of concern. Recently we saw that [ECB Chairman] Mr. Draghi and ECB members want to consider reducing their commitment to quantitative easing. That will have a knock-on effect for what's going on here in the States as well.
And Mr. Abe in Japan politically is under some fire and duress with his policies, because they're not generating the type of economic snapback that everybody was anticipating. One has to wonder how much Japan is going to remain committed to that quantitative easing policy it has initiated and maintained for the better part of the last two years now.
So those are the things that bother us. A little bit of politics, a little bit of policy, a little bit of personnel change.
We want to be concerned about policy changes, but we think we're going to be in a range-bound market. That'll give us some degree of comfort to make very gradual changes in terms of durations and credit exposures and sector exposures without being jerked around too much.
The No. 1 enemy to the markets all the time is surprise and speed of action in the sense of things happening violently. Gradual change is actually quite a good thing in the fixed-income market, and really gives you a much more comfortable world risk. That's what we're hoping for.
Inside ETFs: Let’s hit another hot-button issue: Is there anything about the massive flow into passive products or the rush of flows into passive products that worries you at all?
Smith: The worries about passive products are clearly more a concern on the equity side than they could ever be on the fixed-income side, with the exception of maybe a couple of asset classes, like high yield. Nobody sits there and says, “Oh my god, AGG is completely overwhelmed by all this passive investment; it's going to blow up!” It just doesn't happen.
That's different than perhaps many of the sectors in the equity market; let's say, tech or financials. In fixed income, we don't have those kinds of sector subsets where five stocks will dominate from a fixed-income perspective.
There aren’t five bond issuers that are going to dominate and therefore control all the flows and have a vast shadow of influence over price action within any given group of ETFs. That just doesn’t exist in fixed income.
There is a knock-on effect, I will give you that, in the sense that if things start to go wrong and markets start to go awry, the world tends to live in a matrix, and there are relational effects to all of that.
So if things go wrong in the equity market, and liquidity starts to perhaps be less than what one would feel is optimal, you might see a knock-on effect in some of the high-yield sectors or the more exotic credit areas of the fixed-income market, including those that have a high degree of correlation to equity asset classes, convertibles being another area, perhaps preferred stocks.
It's not there yet, but those relationships and those kinds of correlations are things that we study quite a lot between fixed income and the equity asset classes.
Inside ETFs: We look forward to hearing more about it at Inside Fixed Income.