ETF Edge - Back to bonds… because bonds are back with new tricks? 4/1/24

Episode Date: April 1, 2024

With rates where they are, basic bonds could have another banner year. But a new breed of bond-related offerings could offer investors even more advantages.  Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

The ETF Edge podcast is sponsored by InvescoQQQ, Supporting the Innovators Changing the World, Invesco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things exchanged traded funds, you're in the right place. Every week we're bringing you interviews, market analysis, and breaking down what it all means for investors. I'm your host, Bob Pisani, from 5% yields to active management and the upcoming tax season. We're going deep into new bond strategies with Tony Rocky, managing director and global. head of ETFs at Morgan Stanley and Joanna Gallagos, co-founder of bond blocks. Tony, you launched, what, two big active fixed income mutual funds last week. Before we get to that, let's answer the question. These 4 to 5% treasury yields, everyone's falling in love with, are they going to continue into

2024? Look, at 4 to 5% that's an attractive yield, this is a first time bonds are back, right? People are very interested. We're seeing it in fixed income ETF flows. Last year, a third of all flows into the ETF category went in to bond ETFs. So investors are expressing a view, whether it's an institutional investor or a self-directed investor through fixed income ETFs. Now, do we maintain 4 to 5 percent? Tough to say.

We'll see if rates actually get cut, perhaps as early as June. Now, you launched an old-fashioned bond picket in ETF last week, Eaton Van Gogh. You own Eat in Vance, those you don't know that. Total return, it's EVTR. Is that right? Yes, EVTR. Is the symbol for that. Tell us what goes on in that.

Yeah, so this is a best ideas portfolio. Almost a third of the fixed income category, Bob, is actually core and core plus. So this is really a best ideas portfolio. We actually converted a mutual fund, which we launched in 1984. It's a four-star morning star performance. But we converted to an ETF right here on. the floor of the exchange. That's a good point.

Yeah, last Monday. Now, is this very broad in terms of, like an LQD thing where you're picking treasuries and you're picking Mooney's and you're picking corporates? It's, you know, right now a six-year duration, about a 6.6% yield. But again, it's... 6.6% yield. Yes, but it's a best idea's portfolio. Yeah.

And you also launched a short municipal ETF. Yeah, a shorter on the duration. This is a conversion too as well, right? Exactly. We also converted a municipal bond mutual fund last Monday here at the NYSE to an ETF, Timble, symbol EVSM. And that's a municipal, again, three and a half percent yield, almost a six percent taxable equivalent yield. So these are very attractive rates in the current environment.

You know, it seems like, and this would be for a taxable account, obviously, like a traditional taxable account. The Muni account, we're talking about it. So it looks, there's two stories here, folks. There's the fixed income story, which we talked about and the continuing appeal of that 4 to 5% yield. And there's a little mini boom in active management going on. So there's two stories here, and that seems to be attracting some significant dollars recently. Tell me about, let's talk about the active part. Why is active getting inflows?

Yes, so there was a regulatory change just over four years ago by the SEC. They enacted what's known as the EETF rule. It actually brought new entrants into the market, traditional active managers. like MSNMSA managers, Eaton Vance, Parametric, to the market, almost 20% of all active ETFs, over half a trillion in flows last year, went to active ETFs. If you look through that to fixed income specifically, Bob, I mentioned the core and the core plus.

Right now, almost half of the leading core and core plus ETFs are actively managed. Some of the passive vehicles actually exclude sectors, and so with active management, you can bring in that unique, bespoke approach. Yeah, Joanna, I want to turn to you. The same question, though. I mean, the 4 to 5% yields, they're all in love with, my mother's in love with these things. I'm not getting my mother loves these yields. Is it going to continue in 2024?

I think the cash trade that people were trading in 2023 into U.S. treasuries has been really important for investors to get cash on the sideline, enjoy these yields while they're here. We still think that income is going to be persistent in 2024 and beyond, and we think that, you know, that investors should still be looking at treasury yields and other types of bond investments, because even if rates do decline this year, where people are switching their focus is they're switching their focus to, yes, bonds are back in 2023, but in 2024, investors are getting back into bonds. So they're not only investing in U.S. treasuries.

They're actually looking at these as relative risk assets to the equity markets, which you mentioned. Your biggest mistake could be rushing back into equities before you're considering all these opportunities in fixed income. So, yes, the cash trade and the 4% to 5% is great. We think that will persist. And I think it will be relatively, you know, still very good for investors. But investors should be stepping out into risk.

And we like credit and we like duration. Yeah. So let's talk about that. We last had you on last year. A short term was all the rage. Short maturity, short duration was all the rage. And you've been telling people to move out more into the intermediate end. And those you don't know intermediate would, what, three to seven years, right?

Would that be more intermediate? Why the change? Why should we be moving out here? Well, we think we're at peak rates. So I think what people are looking at over the fence with the Fed is that sometime in 2024 it's projected the Fed will cut rates. It doesn't look like that's going to be the case for the first half of the year, but that's the expectation if inflation holds and inflation continues to decrease. But with a really resilient economy, you really want to be investing in places where the economy is holding up these great investments in fixed income. And so if you can, you guys, you can be investing in fixed income.

going in the intermediate space, whether it's in credit or within treasuries, you're taking on some risk and you're going to benefit from a total return tailwind when rates go down. And there's a lot of high quality in corporations that have issued debt. And there's a lot of, you know, I think, plain, like pretty pragmatic, you know, trade here in just getting out of the short in the treasuries and moving in intermediate space. So on both credit and on treasuries, we like intermediate. Here's your chance how to explain how bomb blocks works a little bit. Let's take the, put up the XHLF. This is the six month. It tracks investment results of an index of Treasury securities. The duration is approximately six months. So explain how bond blocks works. Have you

put up XH? There you go. Thank you. So what we did with X half and we did with all of our treasury funds in in bond blocks is pretty much they give you the same exposure as other Treasury ETFs, but for two important differences. One is we focus on duration. And in our products, it's right on the name of the product, six months duration, one year duration. So X, X-half has just six months duration. And that tells you exactly how much price volatility is going to be in your product. Now for X-half and X1, that's pretty straightforward if you're using it for cash. They're such low volatility.

You know, they're not going to move much. And they're a really great place to get off the sidelines with their cash. Where I think the products that really shines is in markets like 2024, where there's going to be an interest rate change in the short term. And so if you want to move out a little bit, you can do that with precision in bond blocks. targets duration. It does no other product in the market does it. And duration is sensitivity to interest rates. I always have to make sure people under, because they get duration and maturity confused sometimes. Yeah, it's interest rate risk. And so what you would expect in 2024 towards

the end is if interest rates go down, then the price of your bonds are going to go up. And in this market, that's a great thing. In 2023 and 2022, that was an, that made people nervous because as interest rates rise, the price of your bonds go down. And of course, there's bond blocks, it just right out on the curve all the way out of the curve after 30 years. In corporate bonds, most are still yielding north of 4%. And I talked Tony about this. You like the riskier end, the triple B rated. That's the lowest investment grade, folks, on S&P. The yields here north of 5%. North of 5%. Right now, is again, this sustainable? I'm talking about corporates now. Yeah. So corporates have our really attractive place to start investing in and have seen a lot of flows in the first quarter of this

year. We like Triple B. We think it's the place to be because it's the sweet spot of investment grade. If you think of the broad investment category, while this is the lowest part of the risk section of investment grade, you don't pick up any incremental default risk for getting more yield and a better total return potential. In over 20 years, it's outperformed the broader category. So it's just a simple trade to like, if you're going to get back into credit, and you're going to get into, you know, investment gray bonds and corporates. Like, start there with the triple B's. Our favorite is the triple B's, which is the intermediate triple B.

For all the reasons I explained, it probably has the best potential this year. You like bonds an awful lot to both of you. I mean, is there anything you don't, other than like the short end? You were big on Munis. You were big on me. You launched another fund too. Yeah. You like corporates.

You like treasuries. Is there anything we don't like here? Look, I think there's an opportunity cost for sitting. in cash, and it is very attractive at 5% yield. But as Joanna said, and we would agree, we are seeing investors moving out on the duration and the maturity spectrum. One area that is interesting, though, is this sensational demand for income. So we launched the Eaton-V-V-V-RAT, E-F.

Almost eight weeks ago, it's over 550 million. That's E-V-L-N is the symbol, right? The ticker is E-V-L-N. We've been managing floating rates for over 35 years. Explain floater. These are bank loans, right? These are bank loans. What do you own here when you buy this? You own bank loans. And this is a category in, you know, 1989, we helped pioneer in the mutual fund format. When you say floating rate, they actually float, right? So it will move.

Consistent monthly income, and it does float. Right now, our objective is starting a yield of approximately 9%. Now, even if rates go down, as Joanna highlighted, maybe they go down a quarter. What's the matured your typical floating rate loans? Five years? What are they? Well, it depends on the actual issuance, Bob. But we would say even if rates go down, you're at 9%. They go down a half a point, two quarter of a point cuts.

You're still at 8.5% yield on the floating rate. And you're talking about Munis as well. I was just talking to him about this. You launched a new ETF last month for Munis. TAXX, right? Yeah, TAXX. We're really excited about this because when you think about municipal bond portfolios, we really want people to think beyond them, actually,

and look for the relative value of after-tax income. And so this portfolio works a little differently, and it seeks the best opportunity between municipal bonds and non-municipal bonds in the portfolio. And for a taxable account, as Tony mentioned, like, there's so much income and fixed income, you're really going to be not used to paying some tax bills on your fixed income investments, but 2023 you will.

So here, you should be mindful that you don't leave any money on the table with an after-tax yield or after-tax return by seeking all the opportunities in bond funds. So what kind of after-tax return is TAXX going to have after? Right now the portfolios, the tax equivalent yield is close to 6%. It's about 5.88 as you look at it. And when you compare that to other, the big, trade when interest rates were really low was going into short duration credit funds to help you

like step out into cash and use those funds. And so while the yield looks similar on the on the on the paper, if you're not thinking about the tax equivalent yield, it's just the year to be thinking about taxes. Well, you know, six percent. I'm thinking again of my mother, my 95 year old mother, who's delighted she's getting four, four and a half, whatever in her one year bank CDs. But there's a big difference between four and a half and six percent yield at this point. So the, there's a The point here seems to be, I mean, most investors will call me and say, Bob, you're making me crazy trying to figure out whether I should move into this splitting hairs. But 4% and 6% is actually a pretty big difference in returns overall. So they're all not, all these bond funds are not the same.

That's my point here, Tony, right? Yeah, and one of the things that the ETF wrapper enables investors to do, both institutions who use these now and also financial advisors is really get that precise exposure. They can do it through floating rate. they can do it through municipal. I think what's interesting is there's actively managed ETFs now, and there's also certainly passively managed. Some advisors are using passively managed fixed income ETFs to actively manage a portfolio if you think about it.

Yeah, tactically. Tactically. So they're adjusting the exposure based on a building block approach or based on going straight to eat in advance. Do you feel, I'm talking to the choir here, but do you think actively managed bond funds, have a certain advantage over actively managed stock funds. I mean, we've debated this for years.

You know, the track record of active management equities has not been great long term. We know all the studies that indicate most of the time they don't actually outperform, even though they say in volatile times they will. Is there any evidence that you think that actively managed? And I know we're talking about the guy that runs the big organization here,

but is there any evidence that it works any better, active management in bunch? I'm quite certain there's evidence. on both sides. What I can tell you, though, is investors want choice. And they want to be able to allocate, and it's not uncommon to see a financial advisor who has passive exposures alongside active. Very few are one or the other primary. Many use both. So I think that's... That is the smart answer, Joanna, right? I mean, we just give people choice, right? So he avoids the academic debate about this. But your thoughts on this?

Well, I think you summed that really... You're sort of neutral on all this, right? We're generally neutral. We see it as Tony does, I think, which is we don't have a philosophy on one is better than the other. What we think is really important is that clients and investors need help in these markets. They need help from their advisors, and their advisors need help from managers like bond blocks and income research and management that's working on the tax fund. Because when you think about all this big opportunities that we all just described and you're trying to make sense of it, an active manager in fixed income has insights, has a way to help you make. your next decision and that's what's important about I think active management and provider choice and that's how I see it I'm just happy and pick up Tony's point

about choice but maybe not in the way he says it I'm just happy that you know you have 10 year yields north of 4% because it's so much more normal what what's not normal is to give the government money for 10 years at 1% that's just not normal there's no it's crazy who would do that and yet people were forced to do that Now, savers have some way to actually have a real inflation-adjusted positive return, which is it's about time for crying out loud. What's been abnormal, and I know we had viewers complain. They're worried about it.

30-year mortgages going at 6 or 7 percent. But that's what's normal. What's not normal is 3 percent 30-year mortgages. People thought that this was historical? It's not. It never was. So what I'm happy about is things are getting a little more normal the way they should. know if I'm being preachy or not.

No, but we hear that from the clients we work with it. You know, as they said, the outset bonds are back. And when you look at the allocation, equity fixed and other, you know, private vehicles, more and more you can see active management happening in the fixed income sleep. We haven't seen yields like this since before the credit crisis. Yeah. And I think investors, you know, are pleased. Here's the real question, though, is that opportunity cost for cash?

Yeah. You've seen the S&P 500 go up 25% since late October, right? So as investors think about how do I get off the sideline? Higher yields have not crushed the stock market. Yes. They have not. But whether they want to go back into the equity market or now they have choice in the fixed income market. So I know you're not an academic, but we've had 40 years of declining yields essentially since Volcker broke the back of inflation in 82.

It's been really 40 years of a, I guess you call it a bond bear market if you want to look at it that way. But that seems to be ending right now. And do you agree? And is that a good thing? It seems to be a good thing at these levels, at least. I don't want interest rates going through the roof and crushing the economy. But your thoughts? Yeah, well, we'll see.

I mean, the economy is very strong right now. We don't know what rates are going to do this year if they get cut one, maybe three more times. It remains to be seen. But right now, we know our investors are expressing a view into fixed income, ETS more and more? The other issues, of course, and I sound like an academic here. I'm talking to, you know, Wall Street people about academics, and they hate doing this, by the way.

But inflation, global inflation, how it's changing. If you look at what's been going on with the global supply change, with globalization or de-globalization, you know, when you're talking about putting a new FAB factory in New Mexico, billions of dollars, that's going to reduce the efficiency of the supply chains and There's a reason inflation's a little higher and should be higher and interest rates should be a lot. I think, too, there's also the differentiation in all the markets and inflation and different economies. Everything's performing differently. And I think that's another tenant of bond blocks coming to market is that you can start to see the differentiation of these opportunities in fixed income,

which you couldn't see with zero interest rates before. They didn't jump off the page as they do today. And there's a lot of opportunity that needs to be, you have to remind people of the fundamentals of bonds again, you know, how total return works, that it's income and price appreciation, and what happens when interest rates impact those things. And so I think that's another thing we're finding is this massive reengagement with this more normal bond space and rate space that we all lived through and remember. So what does this mean for the ETF space? More mutual fund conversions from bond funds continuing? I mean, this is slowly going on. We've, we're one, just over a year into this, Bob. We've launched 14 ETFs.

We were just over $1.7 billion at the end of the first quarter. Two of the 14 are actually conversions. We'll continue to evaluate our existing mutual fund lineup for conversions, but we're also committed to launching organic new. I do think a number of organizations have looked at converting, but we'll evaluate one by one. Yeah, I think the important thing is investors are finally getting yield, and they're responding to that.

So more product is fine with me. active is fine with me, providing the fees still remain low. I'm a Jack Bogle guy, remember. Jack like active, as long as the fees stayed low. So we're keeping an eye on that for everybody. Thank you both. Very informative. Now it's time to round out the conversation with some analysis and perspective to help you better understand ETFs. This is the Markets 102 portion of the podcast. Let's talk more about bonds with Joanna Gallagos, co-founder of bond blocks. And Joanna, one of the things is quite amazing. You and I were just talking about is the bond flows. When I had you on last year, it was sometime in the middle of the year, we were generally still seeing outflows in the first quarter of

2023 in bonds. People were fleeing them. Then we started to see some modest inflows in the second quarter. And then it sort of just exploded towards the end of the year. Inflows increased rather dramatically into corporates in general. Fixed income was just huge. It's still huge, maybe not as much as it was in three quarters of last year, but people seem to really love their four and five percent yields, and we've commented for a long time how sticky the money is in money market funds as well. Yeah, and the other thing they're doing is they're trusting the resiliency of the economy. In 2022, we probably didn't know which end was up, and in 2023 we're sort of waiting for

something to happen in the economy. We kept getting positive earnings quarter over quarter, positive employment number. and decreasing inflation. And it probably was a lot to figure out and trust in 2023 because we had bank failures and there was a lot going on. But maybe by the end of the year in the fourth quarter, we get to this peak, not only in rates, but also something we can see over the edge of. And I think people are trusting the resilient economy as well.

And so they're willing to take on more risk right now. I think that's what the fourth quarter was about. It was maybe like, okay, now's the time I'm going to come back in to bonds finally. And we saw a shift from short duration and short side of the curve treasury flows into credit and core bond exposures. So that was an interesting first quarter. So the important thing is because you're now getting four or five percent yield, you can reasonably talk about having bond exposures as a significant part of your portfolio. You know, the 60, 40, or 75, 25, or whatever proportion you want is back. Two years ago, there was nobody at any ETF conference I tend to that was no professional financial advisor, no RIA, who was talking about, oh, I'm 60, 40 stocks, bonds.

People were manufacturing income and low vol out of equity products by using derivatives because they understood equity risk better. than they understood bond risk back last year in the last few years, and certainly in the low interest rate environment. And so you got to the point where people were grabbing for so much yield, and they were trying to find, you know, low-val investments and income at the same time, and they forgot that's what bonds do. And now bonds with four-and-five percent interest rates as a base rate, plus credit risk and spread, now it's normal.

Like you said, it's back to the way it's supposed to be functioning in your portfolio, and you may need to get more familiar with the different sectors of fixed income and how they work. Because you can so focus on equities for so long. Well, what's interesting is you can do 4% in, you know, 10-year yield, treasury yields. But as you were talking, you have a muni product with a 6% effective yield. Tax equivalent.

Tax equivalent. Yeah. Thank you. That's the correct word. That's actually a big difference in the fixed income world between 4% and 6%. That's a fairly big difference. Yeah. You shouldn't be leaving anything on the table with fixed income right now.

Certainly not any money related to taxes and income. And this portfolio optimizes across all the sectors in fixed income to deliver your best tax-advantaged return and yield. And that just seems smart because it's actually, in some market environments, it's smarter to pay the tax and grab more yield than it is to just go straight to munis. and we partnered with this amazing manager income research and management. They've been doing these strategies for 20-plus years. They've been managing them for the biggest home offices and institutional investors,

and we're so excited to bring tax to market, which is TAXX. I don't think investors have had these choices before. Yeah. Well, as I said, that everything 4% and 6% is pretty high. And what's amazing to me is we've had this incredible run in equities who are up 25% in five months, who are up 10% for the first quarter of the year.

That's a really remarkable run. I did a story last week. There's only been six or seven times since 1950 where you've had a run of 25% or more in the S&P 500 consecutive monthly five months in a row. And yet we're still seeing significant inflows into bonds. People love these shields. It's remarkable to me.

You think they'd be a lot more fomo, but people seem content. And what is that? that's emblematic of. I think people recognizing the low volatility comparison between bond sectors and equity sectors and understanding all the concentrations and that equity risk that we've been following, you know, for several years, especially within the last year or so. I think people are getting smarter about this market.

I believe investors and the market is absorbing the fact that rates are going to be higher for longer and that there's opportunity for the next one to two years. companies are, their debt is in demand. Corporate issuance in the first quarter was enormous and was just gobbled up. And you're not worried about too much debt. I mean, we see the federal government's going to issue trillions of dollars this year in new debt.

And we keep saying, who's going to buy it? We kept saying the Chinese aren't buying as much anymore. The Japanese aren't, they were one-third of the bond market, the government bond market. I think people feel a little topsy, Turby, you know, equity returns like that and concentrations in risk at equities, you know, I don't think it feels great to be at all-time equity high as knowing what's underpinning some of the economics of our markets and also our economy. So I think that that's another reason

people are looking to bonds because they understand how their returns work explicitly. They're based on debt. It's a different part of the corporate structure if something goes wrong. So there's that appeal as well. Yeah. All right. Joanna, it's been pleasure talking with you. you again I'm delighted to hear I mean you're putting out new products that's a sign that there's a demand right I mean the fact that we've seen I don't know if there's more new ETF bond products than equity products but there certainly seems to be a flurry of them there's a lot of great capability that's coming to market we're working with amazing firms like income research and management to build more

capability for investors to focus on it yeah a lot more to come from bond blocks All right. Joanna Gallagos, head of Bomb Box. Thank you very much for joining us. And that does it for for ETP Edge, the podcast. Thanks for listening. Join us again next week. We're head to our website, etfedge.ccc.ccccccc believes new innovations create new opportunities. Become an agent of innovation. Invesco QQQQ, Invesco Distributors, Inc.