WisdomTree Fixed Income Experts, Kevin Flanagan and Bradley Krom, share their thoughts on WisdomTree’s negative duration ETFs. Moreover, they discuss misconceptions about Fixed Income ETFs, the steepening yield curve, and investing strategies in a rising rate environment. Finally, they provide us with their outlook for interest rates in 2017.
ETFdb.com (ETFdb): Please tell us about yourself.
Kevin Flanagan (K.F.): I am a senior fixed income strategist at WisdomTree. I joined the firm in January 2016 after being at Morgan Stanley for thirty years, where I was a managing director and chief fixed income strategist for MS Wealth Management.
Bradley Krom (B.K.): I am a fixed income strategist and I joined WisdomTree in December 2010. Previously, I worked for three years on a proprietary trading desk that focused on relative value strategies in global interest rate markets. Since then, I’ve been focused on writing research about global markets and helping to launch new strategies.
WisdomTree’s Strategy in the Fixed Income Space
ETFdb: What is WisdomTree’s overall strategy in the fixed income space?
B.K.: I would say WisdomTree’s approach to fixed income investing (and equity investing) is based on the premise that weighting by market cap doesn’t always lead to the most optimal investment exposure. In fixed income, we launched our first actively managed bond strategy in 2010, in order to provide investors with what we believe is a more intuitive exposure to emerging markets. Historically, we’ve tended to have greater exposure to international markets, but over the last several years, we’ve developed strategies that we think can add significant value in U.S. fixed income. As a matter of practice, we’re never going to launch a strategy that we don’t believe can add value to investor portfolios. Primarily, we’re trying to think about how we can potentially add value or provide exposure to a segment of the market that’s hard to access.
K.F.: We take a fundamental approach vs. a market cap-based approach, where the focus is on quality and tilting towards income. For 2017, we are emphasizing a strategy that begins with a core investment (such as (AGGY )) and complements that with a duration hedging strategy to help mitigate the potential for interest rate risk (such as (AGZD ) and (HYZD )).
The WisdomTree issuer page provides you with the full list of WisdomTree ETF offerings.
Misconceptions Surrounding Fixed Income ETFs
ETFdb: What is the biggest misconception that investors have surrounding fixed income ETFs?
B.K.: We spend a great deal of time educating investors on how they should think about liquidity of fixed income ETFs. Today, fixed income ETFs represent about 20% of the industry in the U.S. Some investors are concerned about taking underlying exposures that are traded over the counter and putting them in a wrapper that is traded on an exchange. In our view, greater transparency is a good thing for investors. However, the premise in many articles critical of bond ETFs is that price transparency will ultimately result in a “run” on ETFs as everyone races for the same exit. While it is true that gaps in liquidity can and do occur, I’ve generally been impressed with how normal the market has functioned in the rather dramatic period of rising rates.
K.F.: The biggest misconception is probably liquidity but as we have seen with this latest sell-off in the U.S. Treasury market, this has not been an issue. In addition, the post-Brexit risk-off trade did not offer signs of liquidity issues either on the credit front.
Fixed Income ETFs and Risk Management
ETFdb: Why are investors so complacent about managing interest rate risk? What are other fixed income risks that investors should be aware of?
B.K.: In response to your first question, the short answer is: they didn’t need to be. Over the last 30 years, investing in a strategy benched to the Barclays Capital U.S. Aggregate Bond Index (the Agg) resulted in average annual returns of 6.4% per year, volatility less than 4% and a Sharpe ratio nearly double the S&P 500.
In almost every discussion we have with investors, we reiterate that the best estimate of a bond’s future total returns is its starting yield. Over the last 30 years, the Agg has outperformed its starting yield 20 out of 30 years, which is another way of saying that interest rates have tended to fall. The reason we think investors need to be more cognizant of starting yields for their return assumptions is that interest rates are very low (i.e. returns could be low) and yields are so low; the prospect of negative total returns is a much greater probability because there is less income cushion.
In terms of other risks, the obvious one that we’ve been spending quite a bit of time thinking about is credit risk. The investment thesis of a market cap-weighted bond index is that if a company issues more debt, they should comprise a greater portion on the portfolio. During the later innings of a credit cycle, this is dangerous. In response, this is the reason why we launched our suite of smart-beta fixed income ETFs. In these approaches, we rely on fundamentals and market-based measures of risk in order to determine how to construct the portfolio.
K.F.: Up until the U.S. election, investors had become used to the notion that any rise in rates would be capped out and met with fund inflows. Global central bank policies played a role in this as well as continued concerns regarding economic growth, deflation and safe-haven demand emanating from political/event risks. Post-election, the discussion has changed as interest has grown in utilizing the aforementioned duration hedging strategies.
Steepening of the Yield Curve
ETFdb: Which parts of the yield curve do you see steepening more? What are the implications of this for the investor? What specific strategies can investors utilize to address a steepening U.S. yield curve?
K.F.: Further steepening of the U.S. yield curve is possible for more of the outer reaches of the UST curve, such as the 2-yr/10-yr spread. However, depending on how aggressive the Fed proves to be in 2017, the ‘steepener’ could pivot to a ‘flattener’ if economic growth and inflation expectations disappoint. We have already begun to see the belly of the curve underperform post-Fed, with the 5-yr/10-yr spread narrowing about 10 basis points (bps).
Since rates bottomed on July 8, the yield curve has steepened by 60 bps between 2 & 10 years in the U.S. From a macro perspective, this implies that real economic growth could be poised to accelerate over the next two to six quarters. Short-term rates are rising due to a shift in perception about the pace of Fed rate hikes. Additionally, longer-term rates are rising due to the potential impact on the outlook for inflation from fiscal stimulus. During economic expansions, yield curves tend to steepen. During economic contractions, yield curves tend to flatten.
In a traditional bond portfolio, bond prices fall as interest rates rise. However, in our negative duration strategies, we’re net short duration (i.e. a measure of interest rate risk). Therefore, as the yield curve steepens (long-term interest rates rise faster than shorter rates), these strategies can outperform traditional approaches.
For more on interest rate risk in a rising rate environment, read Duration Hedging and Rising Rates.
WisdomTree’s Negative Duration ETFs
ETFdb: WisdomTree has two ETFs that utilize negative duration to mitigate interest rate risk: WisdomTree Barclays U.S. Aggregate Bond Negative Duration Fund (AGND ) and WisdomTree BofA Merrill Lynch High Yield Bond Negative Duration Fund (HYND ). What inspired the creation of these ETFs three years ago?
B.K.: In early 2013, we were discussing the various ways investors could potentially reduce interest rate risk in their portfolios. For institutional investors, interest rate hedging is an extremely common approach to add value to their portfolios. With this in mind, we approached Barclays and Bank of America Merrill Lynch (BAML) to see if they would be interested in helping us develop an interest rate hedged version of their aggregate and high yield indexes.
For investors that wanted to potentially profit from rising rates or to help offset risk in other interest rate sensitive segments of their portfolio, we also developed a strategy that “over-hedged” the long portfolio to create a negative duration approach.
We chose to focus on the Agg and high yield because these were the primary exposures that investors were already familiar with. The only difference was that we were seeking to add value by altering the exposure to interest rate risk.
ETFdb: The (AGND ) ETF tracks the Bloomberg Barclays Rate Hedged U.S. Aggregate Bond Index, Negative Five Duration Index. How is a negative duration index constructed?
B.K.: We think about these strategies as the combination of two portfolios: A long portfolio that holds the securities that comprise the Bloomberg Barclays U.S. Aggregate Index and a short portfolio that over-hedges the portfolio to a negative 5-year duration. Today, the long portfolio has a duration of approximately six years. Therefore, the index sells securities with a duration of -11 years to achieve the negative 5-year duration target. In this approach, the income collected from the long portfolio helps to offset the cost of being short the securities. Therefore, as interest rates rise (and the yield curve steepens), our short positions generate returns in excess of losses on the long portfolio.
K.F.: In our view, it’s not so much a question of investor type, but rather what that investor’s view is on U.S. interest rates. AGND targets a negative 5-year duration whereas HYND targets a negative 7-year duration. Given that many investors hold a smaller percentage of their portfolio in high yield, we thought it made sense to have a larger negative duration exposure for that strategy. Additionally, high yield is obviously a more volatile asset class with a shorter starting duration; therefore, we actually need to sell fewer securities to target that negative 7-year exposure. We think HYND can do well in an environment where interest rates are rising due to a strengthening economy. Longer-term rates rise due to concerns about inflation and high-yield bonds perform well given the perception of default risk. In our research, we’ve generally found that credit spreads tend to tighten during periods of rising rates. This is why you’ve seen such strong performance since July 8, 2016, as the strategy benefits on both sides of the trade.
Interest Rates in 2017
ETFdb: Where do you see interest rates headed over the next 12-18 months? What are two trends you can forecast for the U.S. and global fixed income space?
K.F.: For the UST 10-year yield, we see a trading range of 2.25% – 3% in 2017. For the Fed, our base case is for two rate hikes next year, with a tilt towards three, if fiscal stimulus is delivered.
A lot will depend on what the Trump Administration and Republican Congress can ultimately deliver on the fiscal front. For the U.S., a drift to higher rates seems the more likely scenario, but not necessarily making new highs.
Globally, issues are still prevalent in the Eurozone (Italian banks) and Japan has yet to gain traction. Thus, there could be a further divergence in rate trends and central bank policy between the U.S. and the rest of the world.
For more Q&As similar to this, be sure to look at our Q&A Interviews page.
The Bottom Line
WisdomTree’s negative duration ETFs are an excellent way of navigating a rising interest rate environment. According to WisdomTree, liquidity continues to be a major misconception surrounding Fixed Income ETFs. Investors must be aware of a variety of risks when it comes to investing in fixed income including interest rate risk, yield curve risk and credit risk. Investors should brace themselves for at least two rate hikes next year, much of which will likely depend on what the Trump Administration can deliver on the fiscal front.
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