Key Themes for Fixed-Income ETFs

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We recently wrapped up the ETF Invest Conference, and I'm here with Tim Strauts. He's a senior fund analyst, and he moderated a panel on fixed income and ETFs. We're here to get his take on the key themes in the bond industry. Tim, thanks for joining me today.

Tim Strauts: Glad to be here, Jeremy.

Glaser: Let's start with a high yield. It's obviously on a lot of people's minds. High yield has really seen kind of a wild ride during the last of couple months with all the talk of the Fed taper. What did you hear in terms of the attractiveness of high yield right now? Has this volatility been warranted?

Strauts: Well, what's interesting about high yield is that fund flows have been very strong earlier in the year, and then just recently in the last few months, we've started to see negative fund flows in the high-yield category. In general, the consensus of the panel was that high yield is still relatively attractive because the panelists generally thought that the U.S. economy was still improving. They thought the chance of recession in the near term was quite low. In general, the questions about the debt ceiling and obviously the government shut down, like most people, I think people at the conference generally though this is this kind of crazy with what's going on [in Washington]. But eventually [lawmakers are] going to come to an 11th-hour kind of agreement and that the markets really wouldn't be that affected by what's going on.

Glaser: The panelists were looking at the high-yield market. Do you think they were interested in taking on more credit risk, or was that duration risk that they'd rather take on with high yield? Where were they finding the most value in this space?

Strauts: What they would say is that they saw that definitely investors are shortening up their duration in high yield. A lot of the funds that look toward the shorter end of the yield curve and high yield are getting a lot of the fund flows. Actually they did say is that in the near term there might be more opportunity in the intermediate-term part of the high yield curve because so many investors are buying those short-duration bonds, that it's creating an opportunity if you're willing to go out a little bit longer in the intermediate space.

Glaser: So there weren't a lot of worries about credit?

Strauts: No. The default rates are averaging in around 2% right now, which is historically a very low level, and over the next two to three years [the panelists] were projecting ranges of 2% to 4% going forward. So no, default rates are not really a concern.

The one concern I guess I would have is that it seemed like everyone was on board, that everything was going be fine, and sometimes when everyone's in agreement, that's maybe not necessarily the time to bet with everybody.

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Glaser: Another place where a lot of people have been placing bets has been on bank loans. There have been big flows into both ETFs and open-end funds that invest in bank loans. What's your take on bank loans? Did you hear a lot of conversation about their appropriateness?

Strauts: Well definitely investors are very interested in bank loans. As far as fund flows, one of the largest inflows year to date is in the bank loan category. We had Lee Shaiman from Blackstone, who runs a bank-loan ETF, and he was very positive on the category. He is an active manager, and he felt that there were still a plenty of good values out there. [Investors are] probably not going to get capital appreciation at this point because the bank loans are trading near par. So, you're pretty much going to look to earn the yield which is right around 4% to 5%, but considering all else, that's not too bad from where we are right now with interest rates.

Glaser: But how appropriate are these funds then for kind of the average individual investor? Is it is a place that they should really be looking to put money to work right now?

Strauts: Bank loans can be a nice little add-on to a fixed-income portfolio because you do get an interest-rate hedge because bank loans are floating-rate securities. As interest rates rise, the interest rate on the bank loan will rise in tandem. I definitely wouldn't recommend a large percentage of your fixed-income allocation, but they can work for a 10% to 15% allocation very well in a portfolio.

Glaser: How about rising interest rates. Does anyone expect [when the Fed actually does taper] to see a repeat of some of the big moves we saw earlier this year? What was the outlook for rates?

Strauts: I generally think most of the panelists were kind of surprised how fast rates rose in the last few months; that kind of caught people by surprise. But now the rates have calmed down. The 10-year Treasury got as high as almost 3% just a few weeks ago, and now it's trading in the 2.6% range. The panelists felt that the Fed is clearly not going to make any moves in the near term. So, it's actually helping out some of the intermediate-term bond funds because rates are going to be stable. They can start earning back some of the losses they've had earlier in the year. As far as interest-rate projections, they kind of felt that it would probably be stable for a little while, but a year or two down the road, yes, rates are going to be rising again.

Glaser: Against that backdrop of rising rates over the next couple of years then, do they have any kind of investment suggestions for the best way to protect yourself against that?

Strauts: Well for a short-term tactical play, one suggestion was actually buying long-term government bonds. I wouldn't recommend that for most investors because that's going to be a very risky play. But that was one idea as far as a tactical play for the very short term. But in general, they felt that intermediate-term bonds, if you're going to be a buy-and-hold investor, were still a fair place to be. You're not going to get tremendous returns, but you're probably going to earn the yield right now with minimal interest-rate volatility at least for the next six to 12 months.

Glaser: And then looking at the intersection of ETFs and fixed income, I know you asked the panelists about if ETFs, or the growth of fixed-income ETFs, is introducing more volatility into the bond market. What did they have to say about that?

Strauts: Some people have questioned, it's been in multiple articles referencing the fact that people feel that, especially in the high-yield bond space, that the growth of ETFs and their high trading volumes may be increasing the volatility in the underlying bond market. IShares actually did a research paper recently, and their research shows that they don't actually increase volatility. Actually they help to reduce volatility because a lot of the trading in ETFs happens in the ETF and doesn't actually happen in the underlying bond market. So, you actually help smooth out the volatility on the volatile days. Now that's iShares' opinion, and some people will disagree with that. But in general, I haven't seen anything just to point to the fact that fixed-income ETFs are making the bond market more volatile.

Glaser: That being said about the overall market, for individual investors, does it make sense to be buying bond ETFs versus the bond mutual fund. What are some of the pros and cons of buying your bonds in an ETF wrapper?

Strauts: I think in general for most investors, you can choose either bond ETFs or bond mutual funds. Where the ETF may have an advantage if you're more tactical and you're looking for a targeted exposure to a particular market because ETFs have more options in the more kind of subsector fixed-income categories. If you're looking for a short-duration corporate bonds, there is an ETF for that. There is not going to be as many mutual funds in that space.

ETFs or mutual funds, it's kind of up to you. I guess finally you would say that ETFs if you need intraday liquidity if you want to be trading at 9 a.m. and selling at 2 p.m., the ETF can work best, but in general for most long-term investors [it's an either/or situation].

Glaser: Tim, thanks for your thoughts on your panel today.

Strauts: Thanks for having me.

Glaser: For Morningstar, I am Jeremy Glaser.