More Innovation Needed In Bond ETFs

Robert Smith is president and chief investment officer of Sage Advisory Services in Austin, Texas. He began his career at Moody's Investors Service as a member of the Corporate Bond Rating Committee. Smith also previously worked at Merrill Lynch & Co. for 13 years in a variety of institutional research, trading and portfolio management roles.

ETF.com recently caught up with Smith to get his take on bond markets and where he sees room for innovation in the fixed-income ETF space.

ETF.com: Why did Treasury yields drop so dramatically this year?

Bob Smith: There's a confluence of different things. While the economy here in the U.S. is a little bit firmer, on a more global scale, things are looking a little bit squishy.

When you're in an environment where monetary policy around the world is still hyperaccommodative—from barely positive interest rates to zero interest rates to negative interest rates in many of the other G10 currencies around the world—that’s going to have a natural drag effect in terms of keeping rates low, even in the U.S.

It also tends to temper Fed policy. Going into the later stages of last year, there was an absolute certainty that we were going to have three rate hikes, we were going to have a higher rate structure, and so forth. Those notions have, one by one, been eradicated. As a result, rates here in the U.S. are very range-bound toward the lower end.

The other thing, too, is that the U.S. continues to be the high-yield alternative in terms of reserve currencies. You're looking at negative rates in Switzerland, Germany and Japan—the countries with the other major reserve currencies. And so a lot of non-U.S. citizens are buying Treasurys as the search for yield goes on. That puts a ceiling on rates in the U.S.

With all that said, rates haven't gone wildly out of control. It's spreads that have gone wildly out of control. It's credit risk that's gone wildly out of control. Everybody's focused on interest rates, but they weren't focused on the credit side and on what happens at the end of credit cycles. Interest rate cycles and credit cycles are not very aligned; in fact, they operate independently very often.

ETF.com: How many Fed rate hikes do you see this year?
Smith: There might be room for one at the back half of the year if everything comes together as planned and things improve overseas. If they don't, it has the ability to drag U.S. economic activity down because we are a trading nation, after all.

ETF.com: You made the point that the rate cycle and the credit cycle aren't necessarily aligned. That's certainly what we saw at the start of this year with Treasurys rallying and corporate bonds selling off. What's your outlook for credit spreads right now?

Smith: Everything in the corporate fixed-income market is driven by the quality of the balance sheet and all the balance-sheet-related metrics with regard to equity, cash flow, interest rate coverages, etc.

Fundamentals across the board are generally weaker than where they were a year or two ago in terms of the strength of American balance sheets. They are more leveraged; the earnings have started to roll over; and top-line revenue growth and the outlook for growth from the managements aren't rosy.

It's not a horrible situation, but not a reason to get a parade together, either. With this backdrop, high-yield and investment-grade bonds were vulnerable to a correction― and that's what we saw.

In the past, you wouldn't see those violent swings in such short periods of time. But you have reports coming out from the likes of Moody's, Standard & Poor's, and so forth, warning of bankruptcies doubling and tripling from where they were a year ago. We're only in the early days of that.

You also obviously have a significant amount of focus that's been placed on the energy sector, which is a large component of the corporate market.

The added ingredient that really created the volatile nature of this correction in credit was the overcommitment on the part of investor portfolios as they searched for yield in this quantitative easing world where everybody's been starving for income.

What did they do? They went walking out the credit plank. Then they fell in and got eaten by the sharks.

A lot of investors are less sophisticated, and they make commitments to these things thinking this is going to go on forever. When they don't, you get these violent swings in very short order. We're now starting to see some reversion back to the mean.

ETF.com: What's your take on junk bond ETFs?
Smith: Recently we exited from that market because we could not effectively isolate the spread risk associated with those credits and those industries and those sectors that we felt were going to be more problematic longer term from those that were being dragged down in tow.

The separation that we see between the different credit qualities—the CCC, the single Bs and the BBs—is fairly dramatic. If you look at the BB quadrant, you're trading today at somewhere in the area of 400-450 basis points over Treasurys. The CCC names are still north of 1,400 basis points over.

That's a huge difference and reflective of the perception of bankruptcies, insolvencies, marketability and all that kind of stuff. It's very event-driven, in an environment where events that are not necessarily investor-friendly are starting to bubble up. As a firm, we tend to wait for that to settle out.

ETF.com: It doesn't sound like you're too enthusiastic about the high-yield ETFs. What about the higher-quality investment-grade corporate bond ETFs?

Smith: Here again, with these wild short-term swings, it's very difficult to get between the cracks with the way the ETFs are designed.

In our individual portfolios, we've taken advantage of some of these swings. But it's very difficult in short-term trading-dominant environments to jump across a broad spectrum of client accounts and to slice and dice into these specialty kinds of trades.

ETF.com: I take it you still see a lot of room for innovation when it comes to fixed-income ETFs?

Smith: Absolutely. The more you subdivide and allow tactical managers like ourselves to get in between the cracks, the better the ETF market is going to be. We need something that’s more scalpel-like than mallet-like in terms of getting at what we want.

Fixed income, as far as we're concerned, is going to need to be more designer friendly, and allow us to capture things like investment-grade differentials, allow us to play in between the industries, and allow us to be more precise in playing the yield curve with size.

We also still have a very limited number of alternatives out there in the ETF world in structured products—such as mortgage-backed securities—that are viable from an institutional perspective. There are some good offerings, but we could certainly use some more.

ETF.com: Do you see these types of products coming to the market?

Smith: People don't see things before the crisis; it's the crisis that unveils the need, and then providers get to work.

That's where the provider has to be careful and ask, "Is this something that's viable longer term; are there enough guys out there that could use this on an ongoing basis; and are we going to be able to make a buck at it?"

One good thing about the ETF market is the creative destruction we see going on. I've always said that the mutual fund world is a world of zombies. How many mutual funds have you heard this week or this month that are closing down?

I can tell you every quarter what the attrition rate is in ETFs that just didn't make the cut.

The beauty and efficiency of the ETF market is if an idea doesn't hold water, for the most part, the big providers kill it.

ETF.com: I was thinking a junk bond ETF excluding energy would have been great for the last year. But is something like that viable long term?

Smith: Why not have an energy credit? Let's take all the big industries. How about just a bank- and finance-only credit ETF? What about a heavy-industry or commodity-industry credit, much the same as we see on the equity side?

We need more than just one provider who takes a whack at this. You need a couple of them to kind of come in and compete with each other and create a more dynamic environment.

The other thing that we've seen is that people tend to jump on things that are either seasonal or don't have legs. What's going to happen with a product that bets on the yield curve flattening?

When the yield curve has already flattened, you're going to have to short that because now we're going back the other way on a secular basis, right? That's not the best.

Things that are highly directional-oriented—where you have to wait for a long period of time for that to round the bend and go back the other way—those things aren't going to get traction, because people don't trade the market that way necessarily.

The gratification isn't there in a more immediate form as an investment manager, and we can construct that ourselves.

Contact Sumit Roy at [email protected].