ETF Edge - Yield signs: Bonds still viable for your portfolio? 8/5/24

Episode Date: August 5, 2024

Amid the market selloff, fluctuating yields have investors taking a second look at their bond holdings.    Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

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I'm your host, Bapazani. As yields fluctuate, are bonds still a viable component for your portfolio? Here is my conversation with Joanna Gallagos, co-founder of ETF firm, Bond Blocks and Jerome Schneider, Pinco Managing Director and Manager of the PINCO, Active Bond ETF. Joanna, I know we were talking before, you're telling clients they should increase their allocation in fixed income. Why?

And what specific areas of fixed income do you like now? Well, I think fixed income is very different today than it was two years ago at the beginning of all this volatility. First of all, we are nearing the end. We all probably agree we're at the end of the great rate hike. So rates are high. And that makes a lot of difference in a portfolio today than it did when we started out with rates being almost at zero. So it can be really important to start looking at fixed income as you diversify and you manage more risk.

So where, tell me a little bit about what you like, though. You were mentioning moving out on the yield curve as well. Give me some examples of ETFs that you sponsor that you like. At Bombolox, we are about precision and being able to pick your spots in this opportunity set in fixed income. And so one of the intuitive things that we were talking about as we came into the show was, you know, as you're moving out of cash and you're looking for the next opportunity, a very simple thing to do if you're not ready to take on any credit risk of the corporations is you can move out in duration. You can move very simply out into the two-year, three-year, five-year. You're not going all the way to the 10 and 20 year, which we saw last year when you get that trade wrong, it can be very volatile. And it has been volatile this year.

At bond blocks, we were talking this morning, and I think the 20 year was down 10% at one point this year, and now it's up 4%. So something in the middle of the curve might be a great next step. So on treasuries as well as corporates here. So I see you have the 5 to 10 year triple B corporate bond. That's BBBI. So you're right in the middle of the yield curve there with the Treasury, XV, XFIV, and the BBBI, right? Yeah. And so the triple BI, what's interesting to talk about there is, you know,

When people think about high quality credit, they think about investment grade. And so their first thought is sort of in the A rating category, AAA, single A, double A. And what they don't probably realize is there's an immense yield pickup as you move to a triple B. So triple B is still investment grade. It has a very low, if any, default rate risk at all.

And you're picking up, I think I checked just a minute ago in the intermediate product, Triple BI, you're picking up an extra 80 to 90 basis points in yield. Just by going up a small, you know, going into triple B's a little bit, you're still getting investment grade, you're still getting really great quality.

Jerome, you manage one of the largest actively managed bond funds, bond ETFs in the world, PIMCO Active Bond ETF, BOND is the symbol, folks. How much will the Fed cut in September? Let's get that on the table. And what are you doing now in that actively managed fund? The Fed would like to cut about 25 basis points or so, just simply because,

they're focused on being sufficiently confident in that inflation beginning to add back to more normalized levels. But the growth prospects, and there's a lot of data, Bob, between now and September, but the growth aspect is really what the market is going to be very focused on, which is why we're sort of perceiving at this point in time, the market is perceiving, a potential for a 50 basis point or even some intermediate cut before the next meeting in September. And while that's not our baseline prognostication here at PIMCO, So we do recognize that this is the beginning of the easing cycle. And we have to rationalize what that means for fixed income investors more generally.

Number one, that cash rates, those in money market funds are going to continue to, you're going to see their yields ebb as soon as the Fed begins to cut that rate. And it could be pretty quickly. Secondly, we also see the value of owning a little bit of interest rate exposure. Again, favoring the front part of the yield curve is a place that we think is most attractive at this point in time. In the two, three, five year spaces, there's plenty of opportunities. across diversified portfolios to look.

And so as we continue this rate cutting sequence, the precision of what the actual rate cutting sequence has isn't necessarily as powerful as having a diversified approach, which offers additional high quality spread and income along the way. And I think that the main takeaway for investors is this, is that they're entering these market conditions with the generally underweight posture to fixed income, recognize that there's a lot of different avenues to participate,

to participate in fixed income, and that takes an active hand in that. And at the same time, while my guessing what the market is going to do in terms of yields or the Federal Reserve is going to do in terms of rate cuts might be something that people would like to do, what we're seeing here is that there are better risk-adjusted returns by being an actively managed fixed income diversified portfolio than there have been in many years. And that's where the invitation is wide open. Still, even as rates have begun to rally for investors to begin to take advantage of those quite attractive total returns at a lower volatility point. It's still amazing to me. One month, 5.3%, 10 years below, you know, 4% now here.

So same question for you. There are expectations the Fed could cut 50 basis points in September. I know you're not an economist, but will they do that? Or what are you telling clients or will they be more measured? Yeah, I think the bond blocks view is that the Fed will be more measured. We are not calling and we don't see a 50 basis point. reduction in September. We think that they, we think that given the economic data from last week and where we're at today, that it is pretty certain that, you know, maybe a 25 basis point cut would be, would likely happen in September. And that's where we stand. We think that, you know,

we need more time and more data to iron out, like, where we're at. Yeah. Is the yield game over at this point? I mean, those people, the viewers, I can tell you, I get emails. They love this 4%. Anything over 4%. They perceive a positive real yield. inflation-adjusted yield. Can you still get north of 4% and stay on the higher quality end of the bond spectrum? Yeah, you're definitely, I mean, I think it's now more than ever to take a look at the different opportunities in fixed income, you have to be able to see them. And so we launch products that you can see lots of different cuts of treasury yields, lots of

different cuts of the way credit is yielding across high, across investment grade and high So we look at this all the time. We can't stop focusing on, you know, yields north of 5% are in investment grade and even further into high yield. Now, it may not be your cup of tea today to talk about high yield, but the truth is that we still, and we're hearing a lot of commentary today, that fundamentals still look strong for corporations. And, you know, especially in the higher quality cuts of investment grade and even in some

the higher quality cuts of high yield, there's opportunity north of five, six, and, you know, all the way down the Reed spectrum down to 12. Yeah, but you, Jerome, she brought up high yield. Give us your thoughts on this. I mean, obviously there's a risk here, a default risk that's very real if the economy slows down. Where do you come down on the high yield side? Yeah, we're beginning to see the need for differentiation

how market risk is being assessed, is being implemented and ultimately tolerated. And part of that is to understand the profiles that underlying credits. First and foremost, let's be clear, This is an environment where having resources both in terms of the understanding of how a balance sheet, a corporate balance sheet is going to evolve in tighter liquidity conditions is going to be important. And having differentiation across the sectors, whether it's high yield, investment grade, asset back securities is going to be incredibly important. So actively navigating these landscapes and just sort of honing in on a yield and a sector because of that isn't necessarily the right ingredients for success.

Instead, we say that there are probably components of high yield, and admittedly today or over the past few days, the lower rates we've seen have actually probably benefited some of those high yield issuers from coming back to market who have tighter liquidity conditions. But it's also a sensitive that we have an outlook right now, and the market is clearly embracing this, that growth is beginning to be a concern. And if that sort of metastasizes over the next quarter, two quarters, three quarters, you might want to be a little bit less credit sensitive in the corporate sectors at this point in time. which is why at PIMCO we're sort of looking at the environment, looking at the landscape, and diversifying into higher quality sectors, agency mortgages, asset-backed securities, things that are more insular in those left-tail risk-off and lower-growth environments. So that the susceptibility to propolis. You don't have a lot of high yield in the B-O-N-D fund, I gather.

Correct. And even in our more income-oriented strategies like a P-Y-L-L-D, we're sort of thinking about as an element but not necessarily an emphasis. And that's where we're focusing on the diversification aspects of being in the markets right now. But it does get you to the point, Bob, of having a four plus percent type of distribution yield of yield to maturity, plus some total return potential, which is ultimately the other side of the coin where investors are going to see that their total returns and their risk-adjusted total returns are what people are really going to focus on as rates become down. And if volatility remains at the forefront of people's minds. Yeah, risk-adjusted return becomes very important in a slowing economy when you're dealing with high yield.

I find that out the hard way. I want to go back to money-market funds because people love these money-market funds. Six trillion dollars in money market funds, astonishingly sticky money that's there. Is that money going to stay there now that yields are lower? Will any of it find its way into the stock market? And I want to get Jerome's opinion too. Yeah, I think cash has been sticky. for over a decade and been on the sidelines.

And so we've seen different ways that clients have moved out or moved a little bit out further from cash. Maybe they've gone into a short-term duration, an ETF, or they've done things like gone into the Treasury trade in the last two or three years. So I think that that balance has always been very hard to crack, for sure. But I think the important thing is that you can still

trade in and out of that when you want to. And I think the ETF is a really important solution for Treasury exposure these days so that you're not sort of locked into either a CD or a money market fund that's frankly probably a little overpriced and there's a lot more price efficiency in Treasury bond ETFs these days you can pay to our viewers they get 5% in some of these money market funds in their retirement accounts yeah you know like vanguard and it's quite amazing that they love it they sit there and they don't even they don't worry that much I think there's a danger in that because they're not looking at what that product is, how much it's charging them.

So if you're getting 5% yield but you're being charged 40 basis points for it, that's not okay in this market because there's a lot of, there's a lot of yield to be to be had in the Treasury side and still in the short-term side and you shouldn't overpay for your cash exposure. I think that's something that they should take away. Jerome, you were making the point earlier about these money market funds that at the amount of money that would probably find its way into the stock market from here is fairly small. But give us your thoughts on how sticky that money is in money markets. Yeah, we've done a few different points of analysis here at Pemcoe.

And the first one is that when you think about the $6.5 trillion sitting on the sidelines in money market funds, it's not all meant to be put to work in terms of risk appetite. It's probably something around 15% by our assessment, which is a huge amount of money, you know, $6 to $800 billion. But at the same time, we aren't finding that it's going to be put to work on a dime, Days like today might incentivize people to put money to work in risk, but not necessarily motivate people to do that. At the same time, what we're also saying is that there's structural reasons why money market fund yields will come down. Obviously, benchmark rates moving down by Federal Reserve easing is the main culprit at this point in time.

And if you forecast that we're going to have five or six rate cuts on the near term horizon, as the market is suggesting, getting closer to that neutral rate of 3%. You're finding yourself moving from a 5% risk-free rate to a 3.5% risk-free rate. pretty quickly on that cash. So how do you balance that? You move to those ultra-short ETF strategies, low-duration ETF strategies, even the bond and core like ETS strategies

that have actively managed components. And in doing so, you find yourself in a healthy way to earn structural premium, earn risk-adjusted returns based on spread products which are more attractive, and at the same time complement the market as it continues to evolve toward a perhaps a lower growth environment than we witnessed earlier this year and an inflationary outlook,

which might be somewhat lower than what we've encountered over the past few years. So having the resources to navigate this landscape is incredibly important. And most importantly, diversification. We think that this environment is a requirement for diversification across asset classes. And so when you look at our complex at PIMCO, generally speaking, our strategies are leaning on that diversified approach across some corporate exposure, asset back securities, other high-quality, assets including agency mortgages. And that's incredibly important as we begin to navigate the different opportunities that changing liquidity fundamentals bring to the market. And that's

where their value ends up being revealed. So Jerome, I'll just a quick follow up. A good part of the bond portfolio, B-O-N-D, the E-TF portfolio you have, is mortgage-backed securities. Mortgage rates have come down over the last few days. I think we're looking at 6.4% mortgage rates now. For people, looking for a home where are mortgage rates going if can you prognosticate on that and where does mortgage-backed securities fit in with a bond portfolio well everybody would like mortgage rates to come down and we think that mortgage rates will come down as as obviously the spreads will tighten from the origination's point of view more practically speaking for investors the way we

think about agency mortgages is a Treasury surrogate a high-quality surrogate plus some spread and while the environment has fundamentally changed over the past year as regional banks have taken a step back from the amount of agency mortgages they're buying, we think it's a great opportunity to use it as a diversifier for our higher quality fixed income ETF portfolio. So for bond specifically, it's been a growing part of that fundamental approach. And what might change is a technical factor about which coupon we buy, things like that. But as a baseline asset class, we think it's a great asset class and a diversifier given the spread components and the quality, nature, and liquidity of

it versus the rest of the market opportunities that we see at this point in time. Do you, Joanna, do you want to take a crack at this? Mortgage-backed securities? Any thoughts on mortgages, Brian? No, I think there's a good point about investing in a multi-sector asset, active, managed, actively managed fund. We have an active fund that does just that. But what it does is it takes a spin on.

Right now, you need someone to help you understand the relative opportunities amongst these sectors. So we violently agree with that. Our multi-sector product is called tax, T-A-X-X, and it has two dimensions to it. One, it's optimizing for your after-tax experience. And sometimes in markets like this, and this is where it'll be interesting to talk about more, is that sometimes it's better if you are an investment-grade securities or you're adding mortgage backs or non-government securities and or munies. And so I think Jerome's right.

There's ways that, you know, professional active managers can help you navigate these opportunities, which aren't as easy to see if you don't have the perspective. But you seem to be talking both sides here. I mean, I'm on Jack Bogle, guys. So Bogle would have argued you should own a broad, diversified bond portfolio. There's a reason AGG is, you know, such a diversified fund. And yet we sort of talk like market timing works. Like we're going to get out of high yield now.

We're going to go more into medium term, medium duration corporates, of medium duration, treasuries, and yet if you own a broadly diversified bond fund, that already may exist. You can argue about the difference between active and passive, but there's a reason why somebody might want to just own a broadly diversified bond fund, isn't there? That's the premise of bond blocks, is that, yes, it was really important for you to be able to own a broad, diversified bond fund. It was really important to have access to that through the ETF and to make your allocations and fixed income so simple with ETS. That was 20 years ago, and these markets are not the same markets they were 20 years.

years ago. They're not the same markets they were two years ago. And so Bond Blocks has products that allow you to see all the different areas of risk and fixed income to be more precise in that broad portfolio. If you build your portfolio with different components, you can put them on, you can take them off as you see fit. So that's one reason. And then the other thing is that that's for a certain type of investor that has a viewpoint and can implement it. There are most of most investors need help and they need a fund that is broadly diversified, and managed for these opportunities that are out there. Yeah, well let me pick up on that, Jerome.

There have been very strong inflows into bond ETFs this year, I think 150 billion, including actively managed bond funds that you do. You've said before active management in bonds does better than active management in equities. That's an interesting observation. Why do you believe active management in bonds can do better than active management in equities?

It comes from a variety of reasons. And you sort of hit on it a moment ago, which was the structural timing or the market timing element isn't really what's driving the returns in active fixed income. Rather, the composition of the indexes themselves lends itself to structural perhaps opportunities over this point in time. If you think about a fixed income, a fixed income universe, and specifically an index, maybe even the ag, it's one that has companies which are based on indebtedness. So the largest positions in that index are going to be the ones that have the highest amount of indebtedness. You may or may not want that exposure. And so as a result, the country segments, how issuers are coming to market in terms of investment grade, etc. Those are opportunities which ultimately change the composition index.

The ability to deviate from that in a rational way using research, using liquidity metrics, and frankly, just looking at what they value opportunities on an absolute and relative basis, that allows you to create opportunities in terms of excess returns to the benchmark rates. So the structural element there is fundamentally different from what you find in the active equity segment. Just leading on one other thing here, Bob, you mentioned, obviously, the flows that we've seen into this segment. From a macro perspective, the fixed income, the actively managed fixed income ETF segment is only about 15% of the total fixed income universe. But yet this year, the inflows are about $50 billion representing, 35% of the actively managed universe. Why is that? Because we're beginning to see that differentiation.

Rates are moving, credit spreads are moving, opportunities are changing. And as those incremental investors come to the marketplace looking for fixed income solutions, they're focusing on how to create and embrace that differentiation, recognizing the fact that they may not necessarily have the tools at their fingertips to do that, but realizing that market practitioners like PIMCO, perhaps bringing those opportunities in a different form in those fixed income vehicles. ETAF vehicles. Before I let you go, I just want to get your thoughts on where you think Banyos might end up. The viewers, I know it's a scoreboard question, about 10-year yields at the end of the year. We're below 4% right now. Where do you think we might end up? I think some of our

research would say we're going to end below 4%. So I wouldn't change anything. So the trend is down, definitely. Trend is down. On yield. Jerome? Yeah, we think there's a few, few things to calibrate here. Number one, what is the term premium market, meaning what does it ultimately mean to own longer dated securities and what are you going to earn by owning those longer data securities? So our view here at PIMCO is that the yield curve will gradually steepen over the next few quarters. And as a result, we probably want to be at the front of the yield. To answer your question more specifically in terms of the 10-year yield, we view it to be fair right around 4%, give or take, you know, 25 basis points or so. But the front end is going to continue to reprise as the Fed continues to

navigate what it used to be proper growth outlooks and obviously inflation outlooks over the next few quarters. That's going to be really the focal point of driving returns for many investors who are specifically focused on active management in the near term. So short-end yields might fall in money market funds, but the total return potentials could increase across all actively managed segments of fixed income. 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. bond blocks continues with us now. Joanna, FT Financial Times recently ran an interesting article

by a friend of mine, Robin Wigglesworth, terrific journalist about how ETFs are coming to dominate the bond market. It was called, ETFs are eating the bond market, which I thought was a great title for an article. And I know bond blocks was participated in that story. How is it ETFs are eating the bond market? I mean, what I took out,

of this and I've known for a while of course is that ETFs are actually helping liquidity in the bond market but what was this story about and why is that relevant so what's hard to appreciate but you would appreciate just sitting here on the New York Stock Exchange is that the bond markets are modernizing and they're digitizing and so there's a lot of of overlap between ETFs and when markets do kind of come into the modern you know format and infrastructure that way so the lot of that article was about the mechanics of the way fixed income trades, how bonds trade, and how it's changing,

and they're trading in surprise, surprise, baskets of bonds, baskets of QSips. Well, 20 years ago, 21 years ago, ETFs came to market. The founders of bond blocks and a lot of people of bond blocks had something to do with launching the very first bond ETFs. And what you were doing is you were getting baskets of bonds and you're having a lot of them trade institutionally. And so that was really, really out of place for a long time. And I just, I feel like the infrastructure of the bond market is catching up. So mostly my takeaway is it was a really great explanation of where bond markets out today and how complementary

the ETFs are to them. What to me was very important is that the ETF tail can wag the dog, the bond dog, the bond market dog and the stock market dog as well. The ETF hate. The ETF hate years ago used to say okay it's one thing to have an S&P 500 ETF but way do you have an ETF of relatively illiquid investments the minute right the minute somebody wants to sell and you get a little selling pressure they're not going to be able to sell the underlying stocks and the whole thing is going to blow up well it the opposite actually happened ETFs have added liquidity to the market and it turns out you could trade

ETFs even without all the underlying actually there we saw this with Chinese equities where they were closed and Chinese ETFs traded without the market being open. It's kind of an interesting, amazing trick here. I remember that article probably 15 years ago where people were trying to figure out how this continuous price for Chinese securities was working. Yeah, I think that what is really, really important about, you know, I don't know if it's the tail wagging the dog, but let's remember there's technology at the center of this article. It talks about how certain firms, invested in technology to better price and better manage their risk in in fixed income and in

portfolios. And some of those firms were head of institutions and banks and folks that you maybe would have thought would have done that first or, you know, would be more more adept to like pricing big, big, big books of risk or big, big portfolios of bonds. So technology is really that is driven that intersection. So I don't know if it's ETF's wagging the dog other than there are firms that invest in technology to better make. an assessment on the risk of bonds every day. And so they're able to move faster. They're able to transfer that risk.

There's a lot of discussion about the transfer of risk amongst bond positions, and that's really what changed. Also, post-GFC, banks' role in taking on bonds on their balance sheet changed a lot, too. And so ETFs helped facilitate that. The key is, of course, understanding that ETFs can trade independently of the underlying assets you could have the ETFs themselves trading and not necessarily have creations and redemptions underneath it but that's what most of the time that's exactly what happens and so even when it's closed the underlying market is

closed let it happen in the Chinese situation people make estimates based upon how they're buying and selling the ETFs on where they think things are going and that has a certain amazing you know power of the of the crowd kind of way of setting prices and also when you you have big volatility events like COVID or the GFC, you know, you can see in a bond portfolio, if there's a big discount to what the fair value is of that portfolio, what that's telling you is like you're able to be, you're able to coalesce and aggregate a lot of information about bond pricing by just looking at the exchange price of an ETF and how it's trading. And those discounts like

help tell you like where where those prices should be at real time. And so one of the key takeaways of the story is that a lot of bond traders are increasingly finding easier to trade bond the ETFs rather than the underlying securities themselves so how is that adding to liquidity for the bond market well there are portfolios of you know a very you know specific cuts in fixed income that didn't exist today that didn't exact exist five years ago our product said is a is a poster child for that you know you're getting cuts of credit and you're getting cuts of duration and you know upwards of hundred hundred hundred to two hundred bonds in in one

you know portfolio whether it's a high-yield portfolio and investment-grade portfolio and you can trade that on exchange in one in one ticker you know to do that and to assemble a basket like that or a set of portfolio that took time if there's a lot of cost along the way in terms of who you're working with with with broker dealers and be able to do that in one trade is is is the innovation in itself that's that's the big story in the cutaway is that you can trade bonds in you know a lot of Q-sips at once and it's very efficient and the price is there and easy to access.

It's quite amazing. And it's a great story, great article there. I'm glad you've got a chance to participate in. Or Bond Blocks did. Thank you, Joanna. Joanna Gallagos is from Bondblocks. And that does it for ETF Edge, the podcast. Thanks for listening.

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