Using Smart Beta ETFs In Fixed Income

September 05, 2017

Kevin FlanaganKevin Flanagan is senior fixed-income strategist at WisdomTree. ETF.com spoke with him recently about the inroads smart-beta strategies are making in the fixed-income space.

ETF.com: This year has been a surprise when it comes to interest rates. A lot of people were predicting bond yields to climb, yet the 10-year Treasury rate is down about 0.30% points on the year. Do you think rates will ever rise above 3% on a sustained basis during this cycle?

Kevin Flanagan: I don't think you're going to see that type of movement any time soon. Our current trading range for the 10-year for the second half of 2017 is in the 2-2.75% band.

The market priced itself for events that hadn't taken place yet—the Trump reflation trade for instance. The lack of progress on the fiscal-policy front in Washington, D.C., combined with some pullback in inflation readings, has changed the dynamic for the backend of the Treasury curve.

ETF.com: Do you think what's transpired this year should change how investors position their fixed-income portfolios? A lot of people were hedging against higher rates going into the year.

Flanagan: One of the strategies we've been suggesting is to take a core approach to fixed income and then combine that with a short duration or even a zero-duration strategy.

That type of a blend makes sense. We can make the case that if you do get some progress in Washington—and it doesn't need to be tax reform, just, say, tax cuts—then the Fed could potentially raise rates one more time this year. That's something the market isn’t priced for at all at this point in time.

As a matter of fact, if you look out to next year for fed funds futures, you're barely at 50% that the Fed is going to raise rates again in March or May of next year.

It also looks like the Fed's going to begin the process of normalizing its balance sheet. If you were to get these forces back into play, we wouldn't be surprised if you saw the 10-year trading above 2.5% again.

I don't have a definitive or aggressive call that rates are going higher, but I think some hedge—given where rates have fallen back to—still makes sense in this environment.

ETF.com: Based on that outlook, which products do you recommend?

Flanagan: We have some zero-duration strategies we like to blend with our core product, which is the WisdomTree Barclays Yield Enhanced U.S. Aggregate Bond Fund (AGGY). That's our enhanced-yield ETF that reweights the allocations or sectors of the Barclays Agg.

We like to use that as our core holding and then either blend it with a zero-duration strategy or a short-duration strategy like the WisdomTree Barclays Yield Enhanced U.S. Short-Term Aggregate Bond ETF (SHAG).

If you were to focus on the AGGY and SHAG blend, you not only can bring duration in under what the current duration is for the Barclays Agg, you wind up picking up about 10 or 15 basis points extra in income. We think that represents a good strategy for fixed-income investors.

 

ETF.com: 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.

ETF.com: 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.

ETF.com: 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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