ETF Expert Corner

iShares’ Matt Tucker Discusses Common Bond Investor Mistakes

May 2nd, 2017 by ETF Store Staff

Matt Tucker, Head of iShares Fixed Income Strategy, explains three common mistakes investors make with their bond portfolios and spotlights several iShares bond ETFs.



Transcript

You can listen to our interview with Matt Tucker by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: I'm now very excited to welcome to the program, Matt Tucker, Head of iShares Fixed Income Strategy. Of course, iShares is the largest ETF provider in the country. They offer over eighty ETFs just on the bond side of the equation, and they offer more than 330 ETFs overall. Matt is joining us via phone today from the iShares headquarters in San Francisco, California. Matt, as always, great to have you on the program.

Matt Tucker: Hey Nate. Thanks for having me.

Nate Geraci: Matt, I'm not sure if you caught the end of our last segment there, but Jason and I laid out three primary reasons to own bonds which were to protect against stock market declines, to have some dry powder on hand, and then obviously to generate income. I'm curious, is there anything else that you would add to that or is that a good way for most investors to think about bonds in a portfolio?

Matt Tucker: You know, I think that's a really good way for investors to think about bonds. If I think about it, people use different terms to describe these things, but I think they all come back to three kind of purposes you laid out. I mean, one thing is we talk about diversification, but it really means when stocks go down, hopefully your bonds go up, and vice-a-versa - gives you some balance in your returns. Dry powder, some folks talk about that as capital preservation, but at the end of the day, it just means that your money isn't going up or down much - it kind of stays where it is. It gives you a chance to have some money to pull on if you want to invest. Then obviously, generating income for a lot of people, especially as you get into retirement, this becomes the big focus - how to actually generate income off my investments. Bonds are a great way to do that.

Nate Geraci: You recently wrote a piece for BlackRock's blog titled “Three Common Mistakes Investors Make with their Bond Portfolio”. I'd like to walk through these. The first one was simply forgetting what your fixed income investment is for. Obviously, we just talked about the primary reasons to own bonds, but you mentioned in your piece that perhaps some of these reasons aren't as appealing in today's environment. For example, yields aren't what they used to be, so income generation is more difficult. What do you think the takeaway is for investors here?

Matt Tucker: Well, you know, I think it's actually interesting. If you think about those three reasons, I don't think every investor starts by asking themselves, “What do I want my fixed income to play in my portfolio? What is the role of fixed income in my portfolio?” If you don't ask that question, you can't really identify what you're trying to do with your bonds. With some folks, they say, "Well, you know, maybe I want some income. Maybe I want some diversification", but if you're not crystal clear about your goals going in, you may end up with a solution which doesn't quite match your expectations. It's your point. In some market environments, you could kind of cheat on this. You go back a decade or two, and short rates are higher. You could basically buy a T-bill, so government-protected, short-term security like a three-month T-bill, earn income on that, and get capital preservation. You get both those things together. If you look at where yields are today, even the 30-year Treasury is only 3%, so you really can't get income and capital preservation today together very easily which means that you kind of have to choose. You have to be very specific about what do I want out of my fixed income portfolio, and then select the investment that matches that goal.

Nate Geraci: Well, and I think to that point, the second common mistake you mentioned you see from bond investors is making investments that don't match your goals. You say, "This may sound simple, but you would be amazed at how often people get this wrong". Can you maybe give us a couple of examples here?

Matt Tucker: Yeah, sure. Let's say that you decide that you really want capital preservation. You look around the market, and say, "Well, I could only get maybe, you know, 1% for a short-term investment," but you think, "Well, I'd really like some income, so maybe I want to kind of cheat a little bit, you know, kind of invest in a longer maturity security or invest in a higher risk security, like emerging markets or high-yield”. Asset classes like that can be great in a broad portfolio, but if your goal was capital preservation, they're probably not the appropriate investment. What I see people do is they drift away from their goal as they get kind of taken by some other idea, some other concept, maybe more yield, and they end up with an investment at the end of the day which actually wasn't what they wanted when they started out. I think just that check at the end of the day, say, "Okay, here's my goal, my stated goal for my portfolio in fixed income. Here's what I'm investing". Then go back and check and say, "Oh, wait, did I still meet that goal?", because again, I'm surprised at how often that drift actually occurs.

Nate Geraci: Now the last common mistake you mentioned you tend to see from bond investors is abandoning bonds when interest rates rise. I think this is one that maybe we're hearing the most about. You say “investors need to be careful not to let the availability of information distract you and steer you away from your plan”. Can you explain this for us, especially as it relates to bond ETFs?

Matt Tucker: Yeah. This is probably the most controversial of the three points, and I think this is a concept about fixed income that not all investors understand very well. Here's the basic idea. Everyone understands this concept that as rates rise, as interest rates rise, the prices of bonds fall. That's kind of a basic principle of fixed income that I think everyone is fairly clear on. The challenge is that, if you think about a fixed income investment not in terms of what it's going to do tomorrow but in terms of what it might do longer-term, what you actually find is that when interest rates rise, the prices of your bonds do drop today, but it also means that if you're holding a fund, like say an ETF, what's actually happening in the fund is the fund is now going to be reinvesting at these new higher yields. Yields go up. The price of your bonds goes down today, but now the fund is acquiring new bonds at higher yields. What that actually means is that over time, your yields start rising. You as an investor get more income. You actually have benefited from rising rates if you hold your investment long enough. Typically for an intermediate investment, if you're going to invest more than five years, you actually like rising rates, because the benefit from the additional income is going to outweigh whatever price loss you incur from rising rates.

Jason Lank: Matt, this is Jason Lank. Welcome back to the show. This is a great visit. One of the things I like to do in finance and also life is follow the money. You may be privy to flows or just have some opinions, but if investors are abandoning bonds or making poor timing decisions, what are they doing with their money? Are they going to cash? Are they rolling the dice? What do you think about that?

Matt Tucker: I think we see two big trends, and we've seen this whenever we see some concern about rising rates. For example, you look at the fourth quarter of last year. The 10-year Treasury rose about 80 basis points over a couple months. We saw some investors moving into cash. They simply said, "Wait a minute. The price of my fixed income investment is falling. I want out of bonds. I want to get out", or they went to shorter duration or shorter maturity fixed income investments. The challenge with both those choices, they both involve giving up yield. Investors basically said, "I saw the price of my portfolio drop. I want to get defensive. I'm going to pull my money out of the market or move to a more conservative part of the market", and in doing that, one, they crystallized whatever losses they've incurred. Yields went up, and the price of their securities fell or their ETFs fell. By selling them, they're actually locking in those losses. Then they're investing in a part of the market that's short maturity or that's a cash investment where you're just going to get less yield, so their income's going to take a hit. I think that if you're looking at an environment where yields are about to rise and you're trying to decide what should I do with my portfolio, you really have to think about your time horizon. If you have a very short time horizon, let's say you're a year or two out, then making that rotation to be more defensive absolutely makes sense. But if like most people, you're actually a longer-term investor and your investment horizon is five, ten years, you are best served by standing pat and just riding out the market fluctuations.

Jason Lank: Matt, iShares has a suite of target date maturity ETFs called iBonds. It's really a relatively new idea over the last five or ten years. Is this a place that fixed income investors might look if they find themselves without the wherewithal to stick to a plan? They know there's an end date. I don't have to decide it for my money. The company will tell me. Is that a place they can look?

Matt Tucker: Yeah, I think iBonds are a great possible alternative. We launched these with the idea of trying to give investors some of the benefits they like about ETFs, so iBonds is like an ETF. It's a managed portfolio. It's benchmarked to an index. It trades on the exchange. You can actually access your money very readily and transact. There's transparency. You can see all the holdings every day. It has kind of these ETF benefits, but the fund itself matures. If you buy a five-year iBond fund, then that fund only holds a bunch of bonds that mature in five years. What happens in five years is all the bonds inside the fund mature. You actually get back all the principal. It gets returned back to you from those maturing securities. The cash flows or kind of the experience you would have with an iBond is actually pretty similar as if you went and bought a bunch of five-year bonds in this case. You're going to get income on a regular basis. In the case of the iBond, it's monthly. Then when all the securities mature, the fund actually closes and makes this lump sum payment that represents all the principal proceeds of the underlying securities. I think if you're an investor who's concerned about rising rates, who wants to have more of a sense of what yields you're going to earn, then much like an individual bond, an iBond is a great way to have that yield experience.

Nate Geraci: Our guest today is Matt Tucker, Head of iShares Fixed Income Strategy. Matt, Jason mentioned the iBonds lineup of ETFs. I'd like to briefly touch on a couple of other iShares bond ETFs as well. One of your most popular ETFs is the iShares iBoxx High Yield Corporate Bond ETF, ticker symbol HYG, which incidentally just turned ten years old. Can you tell us more about this ETF's holdings and I’m curious, where do you think high-yield bonds fit in a portfolio?

Matt Tucker: HYG is a fund, as you mentioned, it's hit its ten-year anniversary. The fund has grown now to be over $19 billion in size. It's a very large, established fund in the market. Like a lot of our other ETFs, HYG is meant to represent a specific market, in this case the high-yield market. It holds more than 1,000 securities. I think that diversification is really important in a market like high-yield where there is more credit risk or kind of risk of default than other parts of the market. It basically is a diversified high-yield fund that kicks off some income. It has a yield over 5% right now, which in this market is pretty attractive given where overall yields are. We see investors use it a lot of different ways. I think high-yield can be a great additive to a portfolio. Given its yield characteristics, if you're adding it into a core bond portfolio or if there's some Treasuries or some other safer fixed income, it can be a way to increase the income in your portfolio without taking on too much risk. I don't think high-yield is where you want to put all your fixed income money, for example, as a riskier asset class, but I think used the right way and used appropriately in a diversified portfolio, it can be a really good source of additional income.

Jason Lank: Matt, certainly ETFs have democratized investing and allow the individual investor to have access to nearly every asset class, and in particular high-yield on a very transparent and cost-effective way, but there's chatter in the industry that there may be a liquidity mismatch - that while the exchange-traded fund may be very, very liquid at the exchange level for the investor, the underlying holdings maybe not so much. There may be a mismatch there, and there could be consequences in times of market stress. Is there any truth to that? What are your thoughts?

Matt Tucker: Well, you know, I think it's a great question, Jason. It's something that we talk about a lot with investors, and it's, I think, one of the most misunderstood things about ETFs. Think about a fund like HYG, so it's a high-yield ETF. 80% of all the transactions that occur, so of all the buying and selling of the shares of HYG, those will happen on the exchange. It's people like you and I. I sell shares to a market maker. You buy shares at the market maker. No bonds actually are transacted for 80% of the trades that happen in HYG. Most of the time, the bond market liquidity is not really a concern, because we're just trading the shares of ETF. When shares of bonds do have to trade, so let's say everyone goes up to the market today and wants to buy shares of HYG, new shares get created in the back end. There's basically a process by which that happens, and this is called creation/redemption. I won't dig too much into details, but the basic idea is that there's a mechanism by which new shares can be created. In that process, there are institutions who will buy high-yield bonds and use those high-yield bonds they purchase to create new shares of HYG. That process, we'll say, "Wait a minute. Now you're trading high-yield bonds. That's different than the actual stock market. Could there be some dislocation or disconnect?”. If you think of HYG, it's been around for ten years, so we've gone through basically almost every financial crisis over the past ten years and this fund has actually been in the market and been trading and been giving investors a way to access the high-yield market. That's through the financial crisis in '08 and the Treasury downgrade in 2011, and even the hiccup we saw in the high-yield market at the end of 2015 when the energy sector was under stress. I think HYG has been tested again and again and again through these market events, and I think what people are realizing is that, "Hey, you know what? This mechanism actually works really well", and that there is this very natural connection between the stock market, or basically where you trade HYG, and the underlying bond market. There's a very efficient mechanism there where institutional investors can basically connect these two markets, trade bonds when necessary, and make sure that HYG is trading at the appropriate price that you and I and everyone else transacts at.

Nate Geraci: Matt, one other ETF I did want to ask you about was the iShares Edge US Fixed Income Balanced Risk ETF, ticker symbol FIBR. What caught my attention about this ETF is that it's a "smart beta" ETF. I think the idea here is that we know certain factors can drive returns in stocks, whether that be value or momentum or quality, but that can also be true in bonds. Tell us more about this ETF and why you think a “smart beta” approach to bonds might be beneficial.

Matt Tucker: I really think that smart beta in fixed income is one of the big next frontiers that we're going to see really start to expand. If you look on the equity side, you've got decades of academic research and funds in the market, and I think there's a growing acceptance and, I'll say, understanding of what smart beta means in equities and how to use it. But it's really early days on the fixed income side. What FIBR, the ticker you mentioned does is it says, okay, if you're a fixed income investor, there's really two things that are going to impact my return. There's going to be changes in interest rates and there's going to be changes in what we call credit spreads or basically the riskiness or the cost of accessing credit in the market. What FIBR does is it says, "Well, I'm just going to basically hold those things in equal weight”. What we know is that, much like how stocks and bonds tend to move in opposite directions, interest rates and credit tend to move in opposite direction. By holding in a fund equal weights of these two risks, I actually get a really interesting outcome. I get actually good risk-adjusted returns, basically meaning that I'm holding a diversified portfolio of these two risks. I get more income than a typical core bond portfolio, and I actually get less interest rate risk or duration. The fund is actually implemented from a rules-based perspective, much like other smart beta funds, to basically say, "Here is kind of a market strategy I can implement in a very efficient way through an ETF”, and then give investors access to this fund which actually has performed really well compared to other kind of intermediate-term core bond funds. I think through the end of April, it was in the top 3% since inception of the intermediate category, so just really providing a very, I think of like a straightforward approach, take advantage of ... not really take advantage of, but really kind of built around this idea of how markets work. It's implemented in a very low cost, consistent, efficient way which has resulted in…so far, it's been very good performance relative to its category.

Nate Geraci: Matt, you mentioned interest rate risk. We have about two minutes left here. Before we let you go, as we talk about bonds here today, obviously one of the biggest drivers moving forward is what happens with rates. If you could, I'd love to just hear the iShares base case on rates moving forward, with our usual caveat that obviously nobody has a crystal ball.

Matt Tucker: Yeah, and I'm probably not going to be super controversial here. I think the main thing for investors to understand is really how interest rates move. People tend to throw around rates. They tend to mean a lot of different things, so I would encourage people to think about it in two ways. Think about short-term rates as being one set of rates that has certain drivers that move it, and think about long-term rates. Short-term rates, we know that the Fed is the biggest driver of short-term rates. They've been pretty transparent about what they're going to do. They'll move one, maybe two times this year. With the rates sitting just below 1%, maybe you get to around 1.5 by the end of the year. Short-end rates we know are somewhat anchored by the Fed's actions, so we probably expect them to be in somewhat of a range. Where there's a lot more of a debate is longer-term rates. They call it the 10-year Treasury which is sitting just above 2.3%. There you see some varying views on where those rates might go. I still think that, given that economic growth is okay, it's positive but not great, inflation is growing steadily but really not a near-term concern, I don't see the 10-year rate moving drastically. It probably goes up a little bit from here. Maybe it gets to 2.5% and 3%, somewhere in that range, so the trend is probably a little higher but I don't think it can move that much higher because you don't have these natural forces, mainly growth and inflation, pushing it up. The other really important piece to remember, and I know it's hard for folks in the US, is you got to look at the global picture. If you look at the world globally, if you're an investor sitting in Germany, your 10-year government security yields about 32 basis points, so 2% less than our 10-year Treasury in the US. If I'm sitting in Japan, my 10-year security yields one basis point, essentially almost zero. There's still going to be a lot of pressure, a lot of foreign investors coming into the US, purchasing US Treasuries and US securities, simply because the yields on a relative basis still look really good. The effect of that is going to be that's going to keep a cap on really how high our yields can go in the US, because they just look very attractive still on a global basis.

Nate Geraci: Well, Matt, with that, we'll have to leave it there. As always, just a tremendous perspective on bond investing and the bond market as a whole. We certainly appreciate your time today. Thank you.

Matt Tucker: Yeah, sure thing, Nate. Jason, good talking to you.

Nate Geraci: That was Matt Tucker, Head of iShares Fixed Income Strategy and if you would like to learn more about the iShares bond ETFs, you can do so by visiting ishares.com. I've got to say, this is a really nice website where you can very easily sort through the different types of bond ETFs they offer and then quickly drill down into the specific bond exposure you're looking for. Again, just go to ishares.com, and then go to the Find an ETF tab.