Using Smart Beta ETFs In Fixed Income

September 05, 2017 What's your take on corporate bonds?

Flanagan: We get a lot of questions about this. Spread levels are at the lowest level in about three years, but we've been down this road before.

If you go back prior to the financial crisis, from 2003 to 2007, the average spread level for both investment grade and high yield in the U.S. was actually lower than some of the readings we're seeing right now. It's not as if we're in uncharted territory here when it comes to corporates.

Are you going to see the same type of returns you've seen over the last year or so? Probably not, because you're looking at different starting points. But we would say the corporate bond market has more value than Treasurys or mortgage-backed securities. There's been a lot of interest in emerging market bonds as investors search for yield. Do you have any thoughts on that?

Flanagan: We think there's a place in a portfolio for emerging markets at this point. You've actually seen a bit of a pullback in the emerging market debt space of late, which we feel is a welcome development at this stage, and helps investors when they're looking for entry points—although we're not advocates of market timing in the bond market by any stretch of the imagination. You've written a lot about factor investing in the fixed-income space. That topic’s new to many investors. What type of factor products do you see as promising, and which investors should even take a look at those types of products?

Flanagan: Anybody looking to put fixed income in their portfolio should be looking at these products. The is moving toward smart beta in fixed income. Equities had their day, and now you're slowly beginning to see the interest grow for the fixed-income side of smart beta, fundamental weighting or whatever you want to call it.

The smart-beta 1.0 was what I talked about earlier, the yield-enhanced strategies—the AGGY and the SHAG.

In smart-beta 2.0, you get involved more in the fundamental weighting. As a bond guy for 30 years, market-cap weighting—which overweights an entity that issues or has the most debt outstanding—doesn't make sense. We should be looking at a different way of investing.

What we’ve focused on in the investment-grade corporate and high-yield markets are factors that help improve credit quality. You're not taking this blanket approach in the corporate market; you're trying to add quality to the mix while also tilting toward income.

Some of the factors we've observed on the investment-grade side were free cash flow, leverage ratio and returns on invested capital. Our work showed that, over time, these three factors helped to be an accurate predictor of when investment-grade firms were ready to get downgraded or could be subject to credit watch by the rating agencies.

On the high-yield side, it was either negative or declining cash flow that was a major force, once again predicting which firms ended up going into duress, if not outright default.

If you can screen some of those bad apples out of your basket, that makes a lot of sense for fixed-income investing.

Contact Sumit Roy at [email protected]


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