The ETF Virtual Summit Features A Timely Fixed Income Discussion
By Roger Nusbaum, AdvisorShares ETF Strategist
ETF Trends, the popular ETF web blog, hosted another successful ETF Virtual Summit on Wednesday. One of the most important segments of the virtual conference was the final segment which was dubbed Creative Income Strategies in a Rising Rate Environment moderated by Jim Pavia, featuring Tim Gramatovich the CIO of Peritus Asset Management, William Belden from Guggenheim Investments and Bill Housey from First Trust Portfolios.
The importance is captured in the title of the segment. The investment industry has mostly conceded that interest rates will have to head higher. Recently Barron’s declared that the 31 year bull market in bonds had ended last May when outgoing Fed Chairman Ben Bernanke put a scare into capital markets with talk of altering the Fed’s quantitative easing policy.
The reality is that most advisors have not had to navigate through a rising rate environment beyond a couple of months. Clients will count on their advisors to help them address this in their portfolios in such a way to provide income without enduring equity-like down side that some bond funds will likely confront whenever rates do start to rise meaningfully.
Belden and Housey were generally on the same side of the trade in terms of the need to prepare portfolios for rising rates.
Belden noted that we have now entered an era of return free risk which is a humorous way of pointing out the dim prospects for plain vanilla bonds. As an example, Belden said that 29 basis point move up the yield of the ten year US treasury would wipe out an entire year’s worth of return because of the nature of how bond prices decline when rates rise. Bonds may not be as safe and secure as investors think which could come as a nasty surprise to clients.
Housey added that there is very little upside today in traditional fixed income although high yield bonds may offer some respite because they have historically outperformed in a rising rate environment. Bank loans and high yield bonds were the best performers in 2013 having positive returns in an otherwise negative year for most segments of the bond market.
Gramatovich took a contrarian view of the prospects of rising rates. Obviously, fears of rising rates stem from what the Fed may or may not do and when they might do it. Gramatovich believes that the move in the ten year US treasury from 1.60% to 3.00% has priced in any actual quantitative easing that might come along in the next year or two.
Part of his reasoning stems from the extent to which pension managers are beholden to “liability driven investing” which means structuring the portfolio in order to meet obligations to pensioners. A three percent yield is high relative to the last few years so when the ten year yield gets to 3% or a little above that level it gets met heavy with “aggressive” buying because that level is so so, relatively attractive. Gramatovich sees this dynamic keeping a lid on interest rates for at least this year, perhaps longer.
Another argument cited by Gramatovich for rates staying about where they are is that the world is still a low growth place and that Europe is a zero growth place. Weak growth won’t come as a surprise anyone and if it remains weak then the time that the Fed actually starts to tighten will continue to get pushed further out which supports Gramatovich’s thesis.
The panel wrapped up with a discussion of where and how to invest in the face of heightened interest rate uncertainty.
An important point made by Housey was that investors were not being compensated adequately for risk taken in more conventional bond market segments. Going forward, the type of hedging done in a long short portfolio may become more conventional by necessity.
The panel collectively believes that the prospects for high yield are very bright. Gramatovich reported that over the last 25 years high yield has actually had a negative correlation to US treasuries which is a compelling argument for high yield over the next few years.
In terms of where to look within the high yield space, the panel noted favorable conditions for lower rated companies to refinance their debt which allows them to extend maturities while at the same time keeping borrowing costs low which has the effect of lowering default rates.
The question then becomes what will these companies do with the proceeds. The panel agreed that companies that invest one way or another to improve their businesses will make for better holdings than companies that borrow money to do things like initiating or increasing dividend payments to equity holders.
The potential opportunities available to investors by selecting more efficient capital allocators contributes to the case for active management in the fixed income market.