WisdomTree Expert on Fixed Income Investing

ETFdb.com (ETFdb): Please tell us about yourself.

Kevin Flanagan (K.F.): I joined WisdomTree last January. Before that, I was the chief fixed income strategist at Morgan Stanley Wealth Management. I’m in essentially the same role now at WisdomTree – I am part of the asset allocation committee and the fixed income spokesperson for the firm as well.

ETFdb.com (ETFdb): What is WisdomTree’s overall strategy in the fixed income space?

Kevin Flanagan (K.F.): One of the key reasons I joined WisdomTree was its different approach, in that we have our own proprietary indices, and base the funds off of them. We are constantly looking at how we can improve upon the current benchmarks that are out there.

A perfect example: market cap-weighted benchmarks for fixed income tend to be tilted toward public debt outstanding. In reality, what these benchmarks do is reward or give the higher weights to those entities that have the most in terms of debt outstanding.

So, in terms of a broader fixed income approach, you see something that would be more tilted toward Treasuries. That’s due to the fact that we ran trillion dollar deficits from 2009 to 2012. So what happens in the environment you’re in, if you’re investing in something that’s tilted more toward Treasuries, you’re going to have more potential interest rate risk. Moreover, you are going to sacrifice income.

The approach we take from a core strategy is how can we improve upon that, and this is how we came up with our yield enhanced multi-sector strategies. On the other hand, if you want to be more specific, and look at say an individual sector, those would be our fundamental strategies, which are in the realm of corporate bonds, investment grade, high yield and so on. In creating those types of strategies, we go straight to the balance sheet, trying to identify factors that we feel can help screen for quality. Then once we do that, with the universe we have left, we then tilt for the income component.

The WisdomTree issuer page provides you with the full list of WisdomTree ETF offerings.

ETFdb.com (ETFdb): How would you define “quality?” What are the criteria you screen for when developing these income-focused strategies?

Kevin Flanagan (K.F.): In investment grade, there are three factors: free cash flow, leverage ratio, and return on invested capital. For high yield, it’s strictly the cash flow side.

So on the investment grade side, once we factor our score, the lowest estimated liquidity 20 percent get eliminated from the index. Then when we move to the high yield aspect, anything that has negative cash flow is eliminated. Five percent of the worst get eliminated as well.

In both instances – high yield and investment grade – if you went back eight quarters in time using these factors, they more often than not helped to predict candidates for downgrades in the investment grade world or financial distress in high yield.

ETFdb.com (ETFdb): Besides interest rate risk, what are some other risks that investors should be aware of when it comes to bond investing?

Kevin Flanagan (K.F.): We’ve been talking about interest rate risk it seems for years, and nothing has happened, until the Trump reflation trade. We’ve had two instances in the last five years or so where you got a snapshot of what potential rate risk could be. There was the taper tantrum in 2013 and then the Trump reflation trade that we just had.

The other type of risk would be on the credit side if you were to get a risk-off environment. If fiscal policy doesn’t happen, there are no tax reforms or tax cuts coming down the pike, Washington gets completely gridlocked, and what you see is what you get, which could create a risk-off environment.

Unfortunately, in the world we live in now, geopolitical developments, say, with what’s going on in North Korea, etc., we’ve had some interesting snapshots of what that could look like. But I think what has been interesting about it is we’ve seen those days where the stock market has responded to the North Korean news, but we haven’t seen the same kind of response, as of yet, in the U.S. credit markets. Investment grade spreads have been really range bound, same in high yield. You get a little bit more volatility in high yield, but on the days where we’ve been down 250 points in the Dow, we haven’t necessarily seen the same kind of corresponding action in the corporate bond market. That’s not to say it can’t happen, but those are the kind of risks.

Another risk would have been on the geopolitical side, especially in the eurozone. There were concerns about the French election and the German election, which now have been eliminated. The Italian banking system still has difficulties. This seems to be hanging over the markets as well. The Fed has started to phase out their balance sheet, i.e. normalize it. The eurozone at some point is going to begin their own taper talk as well. So it would be a potential risk for the bond market as well.

ETFdb.com (ETFdb): What would you say is the biggest misconception investors have?

Kevin Flanagan (K.F.): You can’t talk fixed income ETFs without talking about liquidity. And by liquidity, I mean implied liquidity – the liquidity of the underlying holdings within the ETF wrapper itself.

That’s an important distinction. Because, actually, if you’re looking at firms (especially bond trading desks) out there that are holding individual bonds, they often use the ETFs as the hedge, the countertrade on the other side. So we would argue that’s beneficial for ETFs on the liquidity front, because they’re actually serving as a useful tool to help counter, to be that other side of the trade, that hedge that you’re seeing from the bond desks.

What we try to do in our process at WisdomTree is have some liquidity screens built in. So within the universe that I was talking about before, the high yield fundamental, what we’ll do is we’ll look at, say, the less seasoned, more off the run. So the smaller type of issuers, the five percent, we would eliminate that. What we would try to do is focus more on the liquid type of issues.

We’ve had some interesting type of events occur. Going back to February of last year, there was significant risk off. You had high yield spreads balloon out to over 800 basis points. But if you look at how high yield ETF performed in that environment, there really weren’t any significant hiccups. To me, that’s just a part of the maturation process for fixed income ETFs.

As the investment community becomes more familiar or educated as to how this is working, then you can start to see some adjustments being made. It doesn’t have to be as bad as we initially thought. I’m a big proponent of going back and looking at specific episodes in which market events have occurred, and draw conclusions, instead of always being hypothetical. The market tends to give you events to see how the markets responded. Oftentimes you’ll see similar responses as you go forward, which I thought was helpful, because in 2013 there were more issues – such as the taper tantrum – on the liquidity side. Now we’re finding out three, four years later, that there’s not as much anxiety as we had back then.

Utilize our ETF Screener tool to filter through the entire ETF universe including Fixed Income ETFs by dozens of criteria such as asset class, sector, region, expense ratio and historical performance.

ETFdb.com (ETFdb): What are three or four best practices for an investor when it comes to conducting Fixed Income ETF due diligence?

Kevin Flanagan (K.F.): Track record, tracking error and ensuring you pick the ETF that helps you achieve your investing goals.

Track record is easy to analyze: more money flows into ETFs with longer track records. Investors can also analyze how these ETFs have performed during periods of market stress. Tracking error is important for investors looking to invest in passive ETFs, or any ETF that tracks a benchmark. And before picking an ETF, the investor must ask him/herself: what am I trying to achieve? Do I want to enhance income, increase credit quality or something else? Is this going to be a core or tactical position? Picking an ETF that aligns with the individual investment goals will help the investor over the long run.

Being aware of risks and costs is important regardless of your ETF investing strategy. Read The Hidden Risks and Costs of ETFs to find out more.

ETFdb.com (ETFdb): WisdomTree has some negative duration bond ETFs. What is negative duration? Can you elaborate on how investors can utilize negative duration ETFs in their portfolio allocation?

Kevin Flanagan (K.F.): Interest rate risk is the sensitivity of fixed income instruments to potentially higher rates going forward, i.e. further out in maturity.

If it’s the central banks raising rates, it doesn’t necessarily mean you’re going to have significant duration risk further out, because maturities, once you move further out on the yield curve, are not as sensitive or aligned with an increase in the Fed funds rate. An increase in the Fed funds rate is going to have more of an impact on a one-year, a two-year, a three-year, or even say a five-year type of security. The more you go out on the yield curve, you’re looking at things like the growth outlook, inflation expectations, and risk premiums for around the world.

Negative duration would be a strategy in which you definitively feel that interest rates are going up, and that’s what you want your approach to be, that you want to have some type of vehicle that will take advantage of that. What you’re essentially doing is creating a vehicle that if rates go up, you benefit. The negative duration is going to be a more tactical type of play, where you’re being more aggressive on your rate call.

ETFdb.com (ETFdb): What are reasons for the success of fixed income smart beta in recent years?

Kevin Flanagan (K.F.): Track record is the main reason. The education process is the second reason. The third reason is transparency, which is a huge benefit of the ETF structure. You can look and see what’s under the hood as to what the holdings are, and they’re cheaper, more often than not, than what you’re seeing on the active side as well.

As investors become more educated and more comfortable with that process, you will see smart-beta fixed income ETFs start to rise, as you saw happen on the smart beta equity side.

Read Smart Beta ETFs Can Help You Navigate the Market Cycle to find out about the individual factors within smart beta ETFs.

ETFdb.com (ETFdb): Where do you see interest rates in the U.S. and globally heading over the next two years? How would you recommend investors position, or perhaps reposition, their portfolios for those trends?

Kevin Flanagan (K.F.): In our opinion, I think you’re going to continue to see more of a range-bound environment. But here in the U.S., a lot will depend upon the possible tax reforms and potential tax cuts. Do you get tax reforms, do you get tax cuts? I would say in our base case you will get something. It may not be tax reform, but some type of tax cuts, that will take place. Does that reignite the Trump reflation trade? I’m not so sure about that. But what it will do is create a more challenging environment, especially since Treasuries are not priced for such an outcome.

Right now, Fed funds futures are not aligned with the Fed’s outlook for rate hikes next year. So, if the Fed was to raise rates later this year and a couple more times next year, the market will have to discount that. This isn’t built in at this stage of the game. I think another key part is the balance sheet normalization. We’ve never been down this road before. The Fed can try to highlight it, try to make it seem like it’s not buying this amount. But it doesn’t seem to us that it would necessarily go that smoothly, there will be hiccups along the road. Because somebody else has to buy those securities they’re letting roll off. Foreign buying of Treasuries has been quite volatile lately. Maybe you can’t rely on that as much as you used to in the past. Going back to what I said before, I think central bank policy is going to play a big role. This doesn’t necessarily mean you’re going to see the ten-year Treasury yield go from 2.10% to 3.25%, but could you see the ten-year Treasury trading closer to say a 2.5 to 2.75, or 2.5 to 3 percent band over the next couple years? I think that is a realistic possibility.

For more ETF news and analysis, subscribe to our free newsletter.

When it comes to investing due diligence, track record, tracking error, and ensuring you pick the ETF that helps you achieve your investing goals are the keys to success. Given that interests rates are likely to rise over the coming years, investors may want to invest in negative-duration strategies as a tactical allocation in their portfolios.

Sign up for ETFdb.com Pro and get access to real-time ratings on over 1,900 U.S.-listed ETFs.