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Divergent Trends Favor a Fixed Income Barbell


WILLIAM SOKOL: A few key themes have emerged in 2018 which are divergent in some ways and could be an indication of what’s to come over the next 12 to 18 months. On one hand, fundamentals remain positive and the global economic expansion appears to have momentum. While on the other hand, volatility has come back into the market. From a flows perspective, we are seeing allocations along the risk spectrum by fixed income investors, with large inflows into both emerging markets debt as well as more conservative categories like ultra-short bonds. I’m Bill Sokol, Director of ETF Product Management at VanEck, and I’m joined today by Fran Rodilosso, Head of our Fixed Income ETF portfolio management team. Fran, thanks for being here.


FRANCIS RODILOSSO: Thanks for having me, Bill.


SOKOL: Fran, what might explain some of these trends that we are seeing?


RODILOSSO: Bill, you mentioned the divergent trends and flows in that we are seeing some movement toward very low risk asset classes like ultra-short term debt, floating rate notes, and movement toward emerging markets debt. Both those types of allocation fit our near- to medium-term outlook for rates and for markets in general, if you start, from a policy perspective with the unwinding of QE [quantitative easing], beginning in the U.S., ultimately moving on to Europe, and at some point, Japan as well. That argues for higher rates in developed markets. So you want to protect against interest rate exposure in those markets. Moving toward ultra-short term makes sense from that perspective. On the other hand, with that unwind of QE, what’s our market outlook? Why can that be occurring now? We have a fairly positive global growth outlook; signs of some of inflationary trends, at least a reflationary environment. Those are things that are supportive actually of credit and emerging markets for certain. We are seeing the support for commodity prices, for instance. In terms of foreign exchange, what’s our outlook there? No clear signs of a catalyst for an ending of the negative U.S. dollar trend. With some of the global, geopolitical risks out there, I do not think this is the time to be wildly bearish the U.S. dollar. But on the other hand, international diversification, particularly where you can achieve higher rates or higher real interest rates, such as in emerging markets, still seems to make sense. The outlook is both negative for interest rate duration, over the medium-term at least in the U.S. and Europe, but supportive for credit, supportive for emerging markets, and supportive for currency diversification.


SOKOL: You have laid out a good case to consider both emerging markets local currency bonds as well as floating rate investment grade debt. These seem, in many ways, at opposite ends of the spectrum from a risk perspective. So how could investors use these strategies to position their portfolios in this market?


RODILOSSO: You’re right. It is a risk barbell, as we have been describing it. I think that we talked about why both asset classes might attract investors right now. To break that down even further, both tend to have low correlations to U.S. Treasuries. Your traditional core fixed income allocation is heavy on what’s in the U.S. “Agg” [The Bloomberg Barclays US Aggregate Bond Index]1;Treasury bonds. It is a fairly long duration allocation if you’re in the Agg. But Treasuries, agencies, and investment grade corporate debt, that’s fixed rate. You can use this risk barbell to diversify in two directions: get some floating rate exposure to reduce your overall duration, get some emerging markets exposure to achieve some yield in your portfolio, and get lower correlation to U.S. 10-year Treasury performance. As I mentioned, from a fundamental perspective, things at the moment look okay for most emerging markets. Also, emerging markets have higher real yields than their developed market counterparts. What does that mean? It means their yields are above their inflation rates; they are in positive territory. About 2.5% percent on average. Whereas in the U.S., it is about 0.5% on average real yield. And in developed markets overall, it’s in negative territory. That means emerging markets have a lot more policy flexibility. You will see some emerging markets central banks are still easing this year. It is an asset class where you can still achieve carry and still potentially achieve some capital gains on the rate side. The currency side is a risk, but there is potential for currency appreciation as well.


SOKOL: So a fixed income barbell to diversify away from U.S. Treasuries, but potentially benefit from the tailwinds of global growth?


RODILOSSO: Right.


SOKOL: Are there any other strategies that investors might want to consider in this environment?


RODILOSSO: Not all of the flows that we’ve seen this year, for instance, in emerging markets have gone into local currency debt. In fact, it’s certainly the case for most investors that comfort with emerging markets is still on the U.S. dollar, or hard currency side. We think emerging markets corporate debt is still an interesting asset class. Why? Because, at any level along the rating scale, an emerging markets issuer tends to have to pay a higher yield than a U.S. issuer. I mention that the economic backdrop globally is good for credit; we think it is as good for emerging markets credit as it is for U.S. or developed Europe credits. The high yield space in emerging markets in particular, on average is a double B rated asset class versus a single B rated asset class for U.S. high yield. It is very similar yield and actually slightly lower duration than U.S. high yield. Both are below 4, which is much lower duration than, say, investment grade corporates or Treasuries on average. So we think high yield emerging markets corporates are interesting. We still like U.S. high yield as a diversifier ̶ another carry asset class. But I think investors over the last several years have been more comfortable allocating to U.S. high yield. At this point they may be wanting to diversify that further, maybe concerned about the risk reward. We do like fallen angels within the high yield space still as a way of moving up in credit quality, but still potentially participating in the reasons you go into U.S. high yield, which is generally equity-like returns with lower volatility. The interesting part about the fallen angel asset class as a subset of high yield right now is that is does have a higher allocation to some of the commodity-related asset classes like energy and mining. If you are positive on that sort of global growth outlook, then those higher allocations to those sectors might be something you are comfortable with. If you’re not, then you should consider that when you are thinking about fallen angel exposure.


A third consideration, that combines the credit exposure with floating rate exposure is business development companies. That’s an equity-like asset class. In fact, BDCs trade as equities so they can be somewhat volatile, or at least as volatile as the equity markets are in general. However, these are companies that lend to middle-market borrowers in the U.S. Most of their exposure on those loans is floating rate. It is also senior secured. It is, however, below investment grade. So for investors who like that sort of levered loan asset class, this is an alternative way of getting exposure, a way of diversifying. Business development companies operate under certain sets of rules, some of which have changed recently in their favor. They will be able to obtain slightly more leverage, legally going from 1x levered to 2x levered, though they will tend to stay probably somewhere between 1.4x and 1.6x. It is a high carry asset class; this will enable it to be an even higher carry asset class.


SOKOL: Thank you, Fran, for sharing your outlook and perspective today.


RODILOSSO: Thank you, Bill.


SOKOL: If you would like to learn more, please visit our website at www.vaneck.com where you can subscribe to receive additional insights from Fran and other VanEck thought leaders.