ETF Edge - Betting Big on Bond ETFs: The Hunt for Yield Continues 3/6/23

Episode Date: March 6, 2023

: CNBC’s Bob Pisani spoke with Joanna Gallegos, Co-Founder of BondBloxx – along with Kim Arthur, President and CEO of Main Management. They broke down the resurgence in bond ETFs, as investors continue to clamor for yield. Our panel broke down the biggest trends they’re seeing in terms of bond flows, gave us the lowdown on single-bond Treasury ETFs and explained why perhaps high-yield products shouldn’t be written off just yet. In the “Markets 102” portion, Bob continued the conversation with Kim Arthur from Main Management.  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 InvescoQQQQ, supporting the innovators changing the world. Investco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange 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. Today on the show, we're sticking with the theme of bond ETFs making a comeback. As investors continue to clamber for yield, we'll have another.

expert break down the biggest trends she's seeing in terms of bond flows giving us the lowdown on single bond treasury ETFs, telling us why she thinks that perhaps high yield products shouldn't be written off yet. Here's my conversation with Joanna Gallagos. She's the co-founder of bond blocks along with Kim Arthur, president and CEO of Maine Management. Joanna, we've seen big inflows into your short-term treasury ETFs, a lot of people talking about bonds being back, but do you really think investors should seriously start to increase their allocation to treasuries. When a year ago, everyone was saying the 60-40 stock bond portfolio is dead.

Yeah, well, that was a year ago before the Fed increased rates, 425 basis points last year. So everything shifted in terms of yields year over year. And that number, that 5% number in the two-year is incredible. You know, we're at historic highs for the two-year and the 10-year spread. And it's an interesting time to make sure that you're doing everything you can to get your cash off the sidelines. and get back invested for 2023. Cash has no value at all. My mother called and asked me about two years.

Now, you know, there's a yield top if there ever was one. Robert, I hear about these two years. She always bought CDs their whole life. The only thing you do know, cash is a complete loser. People ask me about what to do all the time. I say, the only thing is 100% is that 5% inflation, cash is a loser.

Yeah, and also, you know, the short end of the curve is really intuitive as well because we're looking down about another 100 basis points of rate. increases. That's what the market's estimating in to the market until around July. So as interest rates are going up, you know, people are a little uncertain about what's going to happen to bond prices, you know, really far out. So if you get into the short side, you know, six months or one year or under two years, again, it's an intuitive trade. This is not 2022. This is not even five

years ago. Yields are very fundamentally different. Kim, as an investment advisor, where do you stand on this whole bond picture? What's the right place for bonds in a portfolio now? Let's at least just start with the short-term treasuries that even my mother is talking about. So we all just stop worrying and buy two-year treasuries? That's what my mother wants to do. Yeah, thanks, Bob. Joanna, good to see you, too. That's a great question, Bob.

I think, you know, we've got some fixed income allocations, and in general, they're yielding about 5%. They're about a four-year duration. They've got a barbell approach where, just like you guys are talking about, We're definitely in the short and for 5%. And then we've got some barbelled with some longer dated treasury, so no credit risk as a hedge against a recession. But I would say to your question, Bob, for the investors and your audience, that one or two year return, what do you do when you get to the end of that period? You have the reinvestment risk. So it's a port of your allocation, but not the entire part because, as we know, over the long haul,

equities will significantly outperform fixed income, and they'll give you that inflation hedge on top of it. So in general, if you're getting four to five points right now, that's kind of your return stream that you're going to see. But then, like you said, the duration side, you have the reinvestment risk. So we, you know, that's how we're looking at it. Yeah, I'm very conscious of that myself. It's what I told my mother. Good for the next two years, but we don't know what will happen after that. I want to give you an chance to explain bond blocks to us before and how it works.

The key points are you own off-the-run treasuries. Define that for us. You target duration. That's a little slippery concept. A lot of people have a hard time understanding duration. Yeah. And, of course, you insist it's a lower cost. So explain how bond blocks ETFs work.

Yeah, so bomb blocks, the company, is the only issuer that's 100% focused on the fixed income investor and dedicated to launching new fixed income ETFs. So we don't have any ties or tethers to sort of the legacy products that are out there. So when we looked at the treasury space, we observed two things. One is, first of all, they needed to have a, their price needed to be updated. It was, this is a, you know, those treasury products have been in market for almost 20 years now. And no one had taken the time to update them to a price. It was more of an institutional level.

So we're bringing institutional pricing back to all investors. And we've significantly reduced. What do you mean? I mean, a lot of these bond funds starts sometimes 15 basis points. What are you charging? Yeah, so we're charging three basis points on the shorter side of the portfolio of the product set. So pricing we thought was really in need of being updated. That's important.

But also what we looked at is we looked at risk. And we wanted to update, we wanted to put it on the label for investors to figure out how much interest rate risk are they taking, especially in markets like these. And we think it was the right call because it gives someone an easy way to look at their interest rate risk that's embedded in their treasury portfolio, which is expressed as duration and expressed in years. So the name of our product represents exactly how much risk you're taking, six months, one year, two year, three year, five year. And we think that's more intuitive for people to put on this exposure in markets like this where we do have expected interest rate hikes coming.

I want you to explain off the run treasuries because we had Alex on last week. He had on the run treasuries, which is you have a two-year, and every month is a new two-year auction, and they roll into that new two-year auction. So you're not holding the old one. That's on the run. You have off the run. Explain what that means. What are you getting?

So Kim actually made a good point. Like, if you buy a single bond in the market, not an ETF, but a single bond, you are going to hold that bond to maturity, and you're going to get back par of that bond. And you're going to have, you would have gotten the coupons of that bond all through that maturity. But then when one year ends or two-year ends, ends, no matter depending on how long that bond was bought for, you have to go back and buy another bond. And that bond is going to be at a new set of rates and a new set of rates. What Treasury ETFs do, all Treasury ETFs do, is they buy bonds and they maintain that exposure

to you. So they roll those treasuries forward for you. So if you always want to put on a one-year treasury exposure or two-year treasury exposure, treasury etfs are the easiest way to do that. The difference between an on-the-run portfolio and off-the-run portfolio is, first of all, the bond blocks products have both on-the-run and off-the-run bonds in their portfolio. It's both. On-the-run is just representative of when a bond is first issued, it's the first-issuant purchase of those bonds. And then off-the-run is like, once a bond has been bought and sold a bunch of times, you can still buy it in the market, but it's just something that's passed its first issue. But in your two-year target duration, XTW. What are you owning exactly in this?

It's a portfolio of U.S. Treasury bonds, and it can have a variety of different maturities in that. But what you're getting is you're getting a specific yield and you're getting a specific duration. So the two-year right now is yielding close to 5% in the XTWO. And you, over time, let's say in two years from now, you were to update that portfolio. Bond Block says it for you. We roll it forward for you. So you can have a persistent yield over time. You don't have to have the inconvenience of trying to go by a single two-year bond.

And we also are specific about the interest. And I want to explain duration to people because it's a hard concept to get hold of. Duration is not the same as maturity. Duration is how sensitive you are to interest rates, right? Yep. So as I mentioned before, the market right now is pricing in, depending on the probability, about another 100 basis points of interest rate hikes. So that's 1% more of interest rate hikes.

And that goes somewhere up to July, so to get a time frame on it. So what you'd be concerned about is take our one-year, X-1, X-O-N-E, the one-year target duration ETF by bond blocks will make sure that you have stable duration in that portfolio. So your risk is exactly one year. And what that means is that for every 100 basis points or 1% of interest rate increases that happen, the price of a bond will typically go down 1%. So it helps you understand the volatility of your price. How do you ensure that you're getting a one-year duration?

What do you have to do? Yeah. So every month, we rebalance the portfolio. We buy and sell bonds that create that exact duration. And so every month we rebalance it and make sure that we buy it. We sell some bonds that aren't delivering the one-year duration, and we buy some that are. And the simple rule is the way I've always understood this, is a dumb, dumb way, I think. If you have a bond that has a two-year duration for every 1% increase,

in interest rates, the price will go down 2%. Correct. Right? So it's a five-year for every 1% increase, five-year duration, for every 1% increase in interest rates, it'll go down 5%. Yeah, and as what Kim was mentioning, if you go out on the longer side of duration,

you're taking on more price risk. And some people want to do that right now because either they want to put a hedge in for if inflation does slow down and we get on top of what's going on. But the intuitive thing that's going on is people are investing on the shorter side of the curve because the volatility is very low.

comparatively. So what's actionable in bonds right now? I mean, people ask me all the time, other than my mother wants to buy the two-year treasuries. Is there something else actionable? I know we've been talking about inflows into short maturity treasury ETFs. What about like longer dated treasuries, for example? What about high yield? Is there a place in the portfolio for that right now? Yeah. It's definitely placed in your portfolio to take on more interest rate, risk with longer dated treasuries, but not more credit risk. However, we think credit risk is really compelling right now, especially in what might feel unexpected in high-yield bonds. So high-yield corporate issuers are probably have gone through something very different than

they have in past distressed markets. So if we're thinking that, we think an economic downturn is coming up, you would think that somebody that is a high-yield issuer may have trouble repaying their debt. And that's just not the case of the fundamentals in these high-yield issuers. They're fundamentals. relatively strong versus pre-pandemic levels. They had a chance to refinance their debt during the pandemic. Really low rates. Rock bottom.

Their leverage ratios are typically are much stronger than they were in other downturns. And we think that investors have been mischaracterizing high yield, even against equity risk right now. And with these yields, so, you know, on the very riskiest side, high yield is in triple C, is yielding over 13%. So comparatively, Kim was also mentioning probably an investment-grade investment, which is targeting around 5.5% of yield.

You know, high-yield you're looking at, in some cases, on single-B, 8.75% and double-b, you know, over 6%. So there's a difference in yield, and you're getting a lot in compensation for the risk right now. Kim, what about that? How about high-yield? I mean, Joanna has a point.

If this is a downturn, it's a pretty strange downturn because normally credit risk emerges rather notably in a downturn. A lot of people seem to believe that and yet we don't actually see it. So talk to Joanna's point here or are you on the same page with her on that or not? Yeah, no, I am on the same page. And what I would add is one other thing. People's most recent experience was 2008 and 9 and that's why they have that recency bias that Joanne is talking about. 2008 and 9 was a true. train wreck. The corporations were broke, the banks were broke, and the consumer was broke. We had a credit crunch. And a credit crunch is a hard landing and really impacts high yield that has credit risk.

Like she said, this is a much different setup. Particularly, it's been more of a rolling recession, so you haven't had everything hit at the same time. You had autos in 2021, housing at the beginning of 2022, goods inventories in the middle of 2020. to commercial real estate here in the back end, technology. So it's been this rolling recession, which, like she said, it allows for that credit to be not as big of a risk. I would say that, you know, you get paid three points over treasuries for those high yield that she said, and it can go up to triple Cs or you're getting more. That gives you your cushion, your protection that you're going to get.

And, you know, there's other alternatives out there that can give you even more protection when that, you know, for that situation. But, yeah, I would agree with her. We're looking also at emerging market debt. We think that there's a lot of interest in that. And the price valuation, the yield that you get and Bob on top of it, it's really highly correlated to the dollar topping, which it looks like the dollar is in the price. process of topping. It's down almost 10% since last year and the fourth quarter. Don't you have the same problem, though, with emerging market debt, when rates go up, emerging market debt has a problem, doesn't it? I mean, isn't that the typical?

Yeah, most of the emerging market indices are heavy on sovereign debt, and they're very sensitive to interest rate risk. And so another way we looked at the market last year was we launched an emerging market debt product that has lower duration, you know, sort of a similar theme of giving more precision to that risk characteristic. And so the product XEMD that we have has actually reduced saturation by almost half. And we saw it really play out in the month of January where the emerging market index, the traditional,

really had, I think it was up, you know, 4%. And it was, you know, mainly related to the interest rate risk of the U.S. economy. So taking that out or dampening that is, we think, probably something prudent, again, facing more interest rate hikes. Kimmy, you've got your own ETS, Sweet. Up there you have the main buy-write ETF. I want to give you a chance to talk about that.

This invests in global equity combined with an option writing strategy. That was very popular last year. Describe what we own here. Yeah, definitely, Bob. So in general, for the alternatives in call writing, this buy W, it excels in a flat to down tape because you have the volatility that allows you to get paid. during that period. So in a year like last year, when fixed income was down and equities were down, this buy W was up 1%. And a year like this year, it's up 5% already. But basically, if you go back to keeping it simple on high yield, what's the premium that you get paid over treasuries to give you downside protection? I mentioned three points. If you do the math and you annualize it out between now and the end of the year, you've got six points of protection from high yield. And a call writing strategy like this by W, you actually have twice as much of protection over

treasuries. You've got six points instead of three, but you get an additional component, Bob. You get this in the money. We can write these calls that are in the money. So if you add the premium over treasuries plus the in the money, there's about 13 points of downside protection or 2x what you get in high yield. So now, in uptapes, you don't. want to have this type of a strategy because you're going to cap your upside. But down tapes,

flat tapes, this is where these alternatives can, these call writing like the buy W can definitely excel. Yeah, and everybody, these were very, very popular products last year. Joanne, I want to we to talk about a favorite topic of mine, which is the modernization of the bond market. Equities became largely electronically traded 20 years ago. You see down here on the floor. When I got here on the floor in 1997, there were 4,000. people around us. They traded 80% of the NYSC on the floor. Today, there's, I don't know, 200, 200 something. They trade 15 to 20% of the end. So big change. But a lot of bonds still trade over the counter. It's amazing to me. How much progress are we making on making the bond market more electronic?

And do we want to make it more electronic? What's standing in the way of becoming more electronic? to update us. It's been a slower transition for the fixed income markets to go more electronic and to modernize. What's really interesting about the intersection of that time in equities, so there was an intersection between ETFs and that time in equities. As they started to digitize on the exchanges, ETFs kind of came into play. And they actually worked really well together. I'm sure you remember, but ETFs, when they traded in the New York Stock Exchange, were

in a room somewhere else where they were trading electronically. So they had some of the first, you know, beginnings of what an electronic, a full electronic market could be for the New York Stock Exchange at the very least. And then all over the interaction of ETFs over that time, bond ETFs are 20 years old today. And they trade the same way that, you know, some of the technologies in fixed income that are just started to grow really faster. It's just portfolio trading. Things are you trading baskets of bonds in a customized way with clients. That's moving very fast. There's new trading platforms that are helping create more transparency to bond buyers.

And it just sounds really familiar to the way ETFs had grown with the equity markets 20 years ago. And there's the sheer number, I always hear from the bond guys. Well, there's too many QSIPs, Bob. There's thousands and thousands and thousands, and it's hard to actually electronify that. Is that just a little bit of a canard? Or is there any truth to that? What's impeding this from happening faster? You know, there are thousands of QSips, but there's also a lot of technology that's been built in fixing the market.

in the last 20 years, where that is not as difficult as a problem to solve. You can easily imagine that. And then, you know, I've got to put a shout out for the ETF markets themselves. They've been operating for 20 years. Fixed income ETF markets have weathered the GFC. They've weathered other different volatility events. And I think this last one in the pandemic really helped in clients see what it's like to have something trade in a structured way, like in a portfolio.

versus on a QSIP by QSIP basis, because you could really source liquidity when you needed it. Even when the underlying products may be illiquid, the ETFs trading, it's visible. It's amazing how the market figures that out, isn't it? It is. It is. It's magical almost. And so I think that to some degree, you know, I want to maybe plant the flag for ETFs, having all of these portfolios in existence and allowing the markets to figure it out over time, build the technology around them. And then for these products to have been tested through so many different events, it just needed, the product needed to exist for people to interact.

with it. At bomb blocks, we see the next generation of that happening. We think it's going to accelerate really quickly from here. And what we observe is there aren't enough fixed income ETS. If you could imagine that, there's only about 15, 70 percent of ETIPs in the market are fixed income. And that's why we wanted to cut it all up into very, very granular pieces so people could exchange all that risk and we can see the next version of the modernization. Now it's time to round out the conversation with some analysis and perspective to help you better understand ETFs. This is the market's 102 portion of our podcast. We'll be continuing the conversation with Kim Arthur from Maine Management.

And Kim, I want to just steer the conversation more towards ETFs in general. I did a whole thing last week about some recent studies on passive versus active trading. Some studies showed that 91% of the trading is still done by active traders. Only 9% is done by passive investors. And I brought this up because there's a lot of concerns that passive is getting to be such a large percent of the ownership of the the market, that it may make the markets less efficient. And yet, well, there's a growing number of people interested in ownership of equities using passive indexes. The actual trading amounts are pretty small. I thought that was rather startling. Only 9% is roughly a passive trading

in the market every day. Yeah, I think, Bob, it's a staggering stat because it tells me two things. There's been lots of people that have saying, okay, these, these, these ETFs are going to take, they're going to cause dislocation in the market because people aren't paying attention to price. They're just adding them to index. They're paying too high. And what that report that you talked about just pointed out, it said, okay, wait a minute. If that's the case, why haven't the active managers been able to ARB that inefficiency? If it actually does exist, Those active managers should be outperforming on a one, three, five, ten year basis. You know better than anyone.

They have not. It's the exception to the rule for the people that have outperformed. So it clearly tells me that this passive kind of tailwind is going to continue to much bigger than one third that it is. And it's not causing dislocation or mispricings in the market. On a separate subject, one of the things that I know. notice last year again is that while ETFs were getting inflows overall, even in a down year, mutual funds were getting outflows. And there seemed to be an additional insult to the injury here. A lot of the mutual funds had very high capital gains. And there was a lot of outrage about

this. This is sort of understandable because there was so much chaos in the markets that a lot of the fund managers were, of course, changing their portfolios around, and this created a lot of capital gains. How did you feel as a guy who runs, as an investment advisor who runs primarily ETFs, watching these very high levels of capital gains? Yeah, Bob, it was the ultimate insult on top of injury. We hadn't seen it since 2008, where you had losses in the underlying mutual funds, and they delivered a capital gains. And the number of people in the fourth quarter, Bob, for clients that we have, we've got, you know, 1,200 clients that we talked to. The number of those clients that had no idea that they were in mutual funds, not through us because we only use exchange-traded funds, but that still had legacy mutual funds and that didn't realize they were going to get a capital gains tax.

It was sheer panic that came in. And again, it shows you the superior construction of these exchange-traded funds where they can affect. do, you know, they can do customized creates and redeems to make sure that you will not get that capital gains. So I think that was another big eye-opener, another one that will continue to move the pendulum in favor of exchange-traded funds and away from mutual funds. I'll tell you something else that showed me, the stickiness of financial assets. You get high capital gains and you still, the cost of mutual funds is just demonstrably higher.

I did a story a few years ago about, and I forget the number, but how many mutual funds, there are mutual funds still charge 2% that are out there. And you think, like, how is that possible? Who is going to own a 2% even an actively managed mutual fund? Who's going to do that? And yet there are. There are people who buy these things and obviously walk away or don't know that much. And it's one of the most frustrating things to see how we talk about this conversion.

Now, money's coming out of mutual funds and ETFs. But, you know, Kim, it's pretty. slow. There's still $20 trillion in mutual funds. There's only $7 trillion in ETFs. That gets smaller. That difference gets smaller every year. But it's gone, it's been pretty slow happening. Yeah. Yeah. And I think there's two things behind it. One, inertia is a powerful, powerful factor. So you've got a lot of advisors that just grew up with mutual funds, have allocated that to their clients, and they just won't move them. You know, slowly they'll move them, like you said, when they're shocks to the system like last year, losses on top of losses. And then there's obviously that

economic incentive. There's still trailer fees, 12b1 fees that advisors will get paid off of. And they're supposed to be doing the right thing in putting the client first, but a lot of times they let the dollar signs kind of dictate where they're going. So you are right. I am constantly amazed that you find people that still have. overpriced mutual funds paying way more than they should. But again, that means opportunity for, you know, firms that go out there and say, hey, there's a better alternative. All right.

Couldn't have to leave it there, Kim. Always a pleasure chatting with you. Kim Arthur is the president and CEO of Maine Management. Everybody, thank you for listening to the ETF Edge podcast. InvescoQQQQQ believes new innovations create new opportunities. Become an agent of innovation. InvescoQQQQ. Distributors, Inc.