Fixed Income Solutions in a Rising Rate Environment
GILLIAN KEMMERER: Welcome to the broadcast, I am Gillian Kemmerer. As the Federal Reserve makes the shift to a normalized interest rate environment where are the opportunities in fixed income? Today, I am joined by Ed Lopez and Fran Rodilosso, two experts from VanEck who will tell us more about where they see possibilities in 2017. Fran, I'm going to start with you. Janet Yellen addressed the University of Michigan yesterday talking about the success of the bond buying program. We are on track in the U.S. for potentially three rate hikes this year, so how does the opportunity set shift in a rising interest rate environment?
FRAN RODILOSSO: That is the trillion dollar question, and you need to think about the Fed's balance sheet and whether we are going to have one, two, possibly three more rate hikes this year? What is the path going to be in 2018? The Fed is going to be looking at ways to shrink the balance sheet, and this makes you initially think about the short end of the curve. But Fed decisions about the balance sheet will impact the rest of the curve, and there are many possibilities in terms of not just short rates moving up but how the whole yield curve will respond over the next twelve eighteen months and beyond. The great news for investors, and the ETF industry in particular, is that there are many potential solutions and tools.
At VanEck we are recommending that given rising interest rates, investors may want to consider shortening duration. This reduces your sensitivity to movements and U.S. interest rates. You can take on more credit risk so you add some yield cushion to your portfolio. For example, if you are investing in high yield bonds, you are already shortening duration versus investment grade corporate bonds, and you're increasing the yield cushion. You can also look for less correlated asset classes that also provide yield. This may include equity income type strategies or emerging market debt type strategies, or if you went to explore the active management side you might consider an unconstrained manager. Again, there are many options for investors.
KEMMERER: These are some very tangible ways to reorient in a rising rate environment. Ed, can you give us your perspective?
ED LOPEZ: At VanEck, we offer a number of different ETF solutions for investors to target rising interest rates. One might be on the credit side on the high yield space or our fallen angel high yield bond ETF (ANGL). On the opposite side of the spectrum is an interesting credit opportunity with short duration is our investment grade floating rate note ETF (FLTR). I think we offer several very interesting options for investors to target income in their portfolio to target and also manage the increase in interest rates.
KEMMERER: Ed, VanEck recently won ETF.com’s “ETF of the Year” award for ANGL, so tell us more about this strategy.
LOPEZ: Our fallen angel high yield bond fund ANGL is one of my favorite strategies. It basically provides exposure to high yield bonds that were once investment grade. These bonds were initially investment grade but for some reason, they have fallen on hard times and their credit rating was downgraded. That's when this Index picks them up and ANGL picks them up as well. What happens is investment grade investment managers are forced to sell these bonds because of their mandate. This creates a valuation opportunity, or valuation disconnect. When we launched this ETF in 2012 the Index already had a long history of consistent outperformance of the broad high yield bond space, and over the last five years since we've ANGL, its investment thesis has been proven. [The Index referred to is the BofA Merrill Lynch US Fallen Angel High Yield Index (H0FA).]1
KEMMERER: Fran, can you tell us a bit more about the success of the strategy?
RODILOSSO: I think an interesting aspect of this strategy is how bonds tend to get cheaper going into these downgrades right before they enter the Index. The good news we've noticed, since the launch of the Index and also since the launch of ANGL, is that fallen angels tend to be lagging indicators. In other words, sometimes the ratings agencies are a little bit behind the curve not just on individual issuers but on entire sectors. We saw that most recently in early 2016 when there was a big wave of downgrades in the energy space and some in the mining space. These sectors became two of the largest weightings in the ANGL portfolio, and this happened just as commodity prices were bottoming out. You know there is some intelligence to the construction of that Index.
KEMMERER: Speaking of the construction, I have heard this strategy referred to as a “smart beta” strategy. How do you apply the smart beta mindset to fixed income?
RODILOSSO: Smart beta is such a funny term, and not everyone loves it. At VanEck we try to think in terms of choosing indexes that, one are replicable and investable, but also we are also looking for more intelligent ways to approach markets. Some people apply a very strict definition of smart beta. The irony of fallen angels is it is actually market cap weighted but it's a subset of the broad high yield universe, and those fallen angel bonds tend to have some different characteristics and the Index tends to have different characteristics from a weighting point of view. I think we take a smart approach at VanEck, and Ed actually came up with the idea of launching an ETF around fallen angels. He had been looking for new ideas and that is the sort of the process we follow at VanEck, looking at what is out there, and in this case, trying to improve on the high yield space. Fallen angels are a way of keeping the smart beta approach simple. This is the other thing we think about at VanEck, is the investment strategy explainable? Is it simple? And what might make our thesis work.
LOPEZ: I think one of the brilliant things about the fallen angel strategy is its simplicity, as Fran mentioned. Basically it embodies what good investing is and the way an investor would approach investing in any market. That is to identify quality and to buy it at a good price. Fallen angel bonds, because they were once investment grade, tend to be large companies with a brand name and for whatever reason they have been downgraded. Fallen angels as a whole tend to be primarily BB rated, so they are at the higher rung of the high yield space. This is a really interesting aspect of the story to me, which was the higher quality high yield and with that valuation component to it. It offers what I think good investing is intended to do, by identifying quality at a good price.
KEMMERER: I'd like to move to another product that VanEck offers and that’s FLTR. Fran can you explain to us why this particular strategy is well suited to a rising interest rate environment.
RODILOSSO: When we talk about some of the ways to deal with higher rates in your portfolio, we talk about shortening duration. FLTR is one of the ways to move to a very short duration type fund. It is a diversified portfolio of investment grade rated floating rate notes, which are bonds effectively whose coupons reset quarterly. They are a spread over LIBOR, is how these coupons are set [The LIBOR rates, which stand for London Interbank Offered Rate, are benchmark interest rates for many adjustable rate mortgages, business loans, and financial instruments traded on global financial markets.] So as LIBOR ratchets up, as the Federal Reserve ratchets up rates, coupons on these bonds will adjust every three months, to keep up with the Fed, if you will. The duration is incredibly low FLTR. You get a little better yield than you would in Treasury-bills or government issued floaters. Because it is investment grade credit and you are still getting that credit spread. FLTR also has an interesting index construction that I think helps enhance the yield.
LOPEZ: There is an intelligent design behind FLLTR where we have evaluated the market and identified that on the longer end of the spectrum, or in terms of the maturity, you could pick up higher yields. Longer term bonds will have a higher yield. But because they’re floating rate notes and they reset on a quarterly basis it doesn't really affect their duration or the interest rate sensitivity. You can keep low interest rate sensitivity in your portfolio and pick up a little bit higher yield potentially. You might do better than just a broad academic index. Now what that does to do, I think Fran can probably talk to this point, is it creates a little bit more exposure to credit and so you have credit duration. That is a risk to take into account. But perhaps the outlook for rising interest rates, the improving economy that might be a risk you might want to take on.
RODILOSSO: Yes, that is right. It has a higher sensitivity to movement in credit spreads but this is an investment grade Index. So credit spreads are not as volatile as they might be in for example a high yield index. If you look at one of the larger issues in the Index as an example, a four year JPMorgan Floating Rate Note [FRN] has more credit risk than a one year FRN in the sense that its credit spread might move. However, the default risk for the JPMorgan FRN, whether you're on a one year or four year is the same.
KEMMERER: To summarize both of these points, Ed, tell us how ANGL and FLTR really typify the way VanEck rolls out products.
LOPEZ: I would wrap it up as just intelligent design. What I mean by this is that we try to identify what the outcome we're trying to solve for. And then we also look at the market place and how would an investor actually approach that market? It may not be a just a cap weight approach like an academic might. It might be, as we talked about with FLTR, looking at where you might be able to source higher yield. What does that do to the risk return parameters of the portfolio? Looking at liquidity parameters, size, exposure, different things. We try to approach it like an investor might. The result is, some might refer to that as smart beta. I just refer to it as just smart investing.
KEMMERER: That's a great note to end on. Gentlemen, thank you so much for taking the time to tell us more about VanEck and the rising interest rate environment.
VanEck’s Ed Lopez, ETF Product Management and Marketing Head, and Fran Rodilosso, Head of Fixed Income ETF Portfolio Management, identify fixed-income ETFs that aim to help investors tackle rising interest rates.
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1 Outperformance is measured by BofA Merrill Lynch US Fallen Angel High Yield Index (H0FA) versus the BofA Merrill Lynch U.S. High Yield II Index (H0A0).
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