ETF Expert Corner

iShares’ Matt Tucker Discusses Current Bond Market, Spotlights ETFs

May 3rd, 2016 by ETF Store Staff

Matt Tucker, Head of iShares Fixed Income Strategy, offers his perspective on the current bond market, discusses individual bonds versus bond ETFs, and spotlights several iShares bond ETFs including AGG, TIP, & FLOT.



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 pleased to welcome to the program Matt Tucker, head of iShares Fixed Income Strategy. Of course, iShares is the world’s largest ETF provider. They offer over eighty ETFs, just on the bond side of the equation, and they have some three hundred and twenty five ETFs overall. Matt, as always great to have you on the program.

Matt Tucker: Hey, good morning Nate, Thanks for having me.

Nate Geraci: Matt, before we get into bonds and bond ETFs today, I thought a good starting point might be to briefly touch on last week's Fed meeting because the Fed has certainly impacted the way investors have approached the bond market over the past several years. Did anything stand out to you from the Fed's statement? What do you expect to see, moving forward?

Matt Tucker: I think that the meeting and the statement went pretty much as the investors expected. The Fed, for a long time, had interest rates at zero. They raised rates for the first time in a while, this past December. I think investors have been looking for the next Fed move when the Fed's ...they have been patient. They've indicated they're going to be patient. They're going to evaluate the data. They're going to look at growth, look at inflation. It wasn't going to be a move in April. It's probably not a move in June. If you believe the futures market, investors are expecting the Fed not to move until later this year, probably around December. I think investors should expect the Fed's going to continue to communicate and to be slow and steady and that, barring a real big pickup of growth or inflation, they're probably going to sit tight with where rates are right now.

Nate Geraci: If you look at where bond ETF investors have been placing their money recently, they've been moving out of treasuries and into riskier parts of the bond market, investment-grade corporate bonds, and high-yield emerging market debt. I'm curious, what do you make of this, and how does this maybe square with what we've seen out of the Fed recently?

Matt Tucker: I think it's been interesting. You've really seen a tale of two very distinct markets so far, in 2016. If you think about the first six weeks of the year, we had a period of real risk-off. Investors were very concerned about global growth. They were concerned about what's happening in global equity markets. You saw money coming out of pretty much any risky asset. That includes high-yield bond funds. That includes emerging market bonds. It includes equities. You saw money coming out of ETFs, out of mutual funds. A lot of that money ended up in very safe asset classes, like US Treasuries. That was really the tone for the first six weeks to around February 11th. Then you saw this change in sediments. You saw oil rebound. You had some noises out of the Fed. They were a little more constructive on growth, and you've seen this amazing risk-on rally over the past two months now. Money has been, as you said, coming out of US Treasuries and going into other parts of the market. The way I think about this generally is investors have become comfortable again taking risk in fixed income. That means taking credit risk through things like investment grade corporate bonds or high-yield. It also means taking risk in terms of interest rate risk by buying longer duration, longer maturity funds and being coupled that the Fed is probably on hold and we are probably not going to see a spike in inflation that might hurt those longer maturity assets.

Nate Geraci: Matt, for the average investor out there: how do you think they should be approaching bonds in their portfolio? Just at a high level because Conor and I talked in the first segment about how we tend to view bonds. It is more of a ballast in a portfolio, not necessarily a place to load up on risk but it’s certainly clear, and some investors are moving towards riskier areas of the bond market like high-yield and emerging market debt. I think that's been a trend in place for several years now. Should investors use bonds for stability? Should they pursue risk? Is it both? How do you view this and how should investors balance risk and reward when it comes to bonds?

Matt Tucker: You know Nate, I think this is a key question. I think if you think about how a lot of investors look at their portfolios and even if they sink them I think the biggest mistake people make is that they over manage them. If I think about the fixed income portfolio and we're out talking to investors, talking to advisors overwhelmingly the majority of people say the role of fixed income in their portfolio is ballast or diversification against equities. If that's your goal you don't want to take a ton of risk. You shouldn't be chasing yield, you probably don't want to be very tactical. I think that the most prudent path for most investors who really want fixed income to play that role of the anchor: you want a diversified portfolio fixed income, you want to own some credit risk some corporate bonds in there, municipals if you're a tax investor. You do want to have some interest rate risk because that actually helps give you that balance against equities. You want a diversified fixed income portfolio, then you probably want to leave it alone for the most part. I think that fixed income really does its best job when you're not trying to time the markets which is incredibly hard. For most investors they are best served over the long term by building a nice, stable, core fixed income portfolio and just letting it do its work.

Nate Geraci: Again, we're visiting with Matt Tucker head of iShares Fixed Income Strategy. Matt, regardless of whether investors take a more conservative approach to bonds or riskier approach there is of course no shortage of ETFs to help. Earlier, Conor and I touched on what we believe are some of the key potential benefits of investing in bond ETFs versus individual bonds. I'd love to hear your thoughts on this, why do you think bond ETFs might be a better way to go for investors?

Matt Tucker: I think there's some real challenges that most investors face if you want to invest in the bond market directly. If you think about the experience, the average investor goes to the broker, goes to try to buy a bond, A) there's no exchange to look for your bonds. It's like, "Well how do I find out what's available?" You see a list of bonds probably on your online site or from your broker, you're not quite sure if those are the right bonds or the wrong bonds it's hard to do research on them. We get a price for them, we're not really sure if that's a good price or a bad price. You often just get one price from one broker or dealer and is 101 a good price? I don't know, I have nothing to compare it to. With an ETF, these things trade on a two way market on the exchange that looks just like a stock exchange so I can see the ETF where I can buy it, where I can sell it, I know the transaction cost I’m paying. The first big difference for me is that the way you engage that market and the way you invest in the market is much easier and more accessible with the bond ETF market than it is for bonds.

Second big thing is diversification. If you're out buying bonds, especially say corporate bonds, you don't want one or two or even four or five, you want diversification. By buying a fund like an ETF, you gain access to hundreds or thousands of bonds with one trade. Which I think is a really important part of risk management in a portfolio. The third thing, this is really important is, costs tend to be fairly low in bond ETFs. Look at the really big funds, I'll take AGG which is our core aggregate fund. They have eight basis point management fee, and that's a really low fee compared to most other fund options out in the market. You have an investment that is diversified that's not to cost you a lot in terms of transaction costs or fees and we can actually go buy it, put it in your portfolio, and actually can keep an eye on it every day I think is really important.

Nate Geraci: All right Matt, if we can I'd like to just briefly touch on three of the more popular bond ETFs offered by iShares. I thought we'd start with an ETF you just mentioned, the iShares Core US Aggregate Bond ETF ticker, AGG. Can you just tell us what this ETF holds and maybe where it might fit in an investor’s portfolio?

Matt Tucker: Sure, so AGG is the iShares Core US Aggregate Bond ETF. It holds investment grade bonds issued in the US. Think of it as, people call it kind of the S&P 500 of the bond market. It's your big diversified benchmark. We typically see this sitting at the core of someone's portfolio, it's basically kind of that core piece of your portfolio that you build everything else around. AGG is a fund, it is the world's largest bond ETF with about $35 Billion in assets and actually one of the oldest ones in the market, it was launched back in '03. This is really, I think of it as this kind of bread and butter, if you're building a portfolio, a great place to start. A great place to begin that portfolio build and then you can add other pieces around it depending upon your risk tolerance in your investment goals.

Nate Geraci: The next ETF I have is the iShares Tips Bond ETF ticker TIP, this owns treasury inflation protected securities. Should investors be considering inflation protection now and how can TIP help?

Matt Tucker: TIP is really interesting. If you think about TIP securities these are bonds issued by the treasury and what's different about them is the treasury actually compensates you as a bond holder for increases in inflation. You're getting your coupon bond every six months if you hold a TIP security and as inflation increases you actually get more income and you actually get more money back in maturity. It's actually the only investment out there that actually pays you directly for inflation. We talk a lot about inflation hedges like gold and real estate and things like that but TIP is the only security that gives you cash for inflation. There's no correlation to worry about, you get paid for it. A fund like TIP invests in a broad US Treasury TIPs market. For investors looking to build in some protection against inflation or some diversification in a portfolio. I think it has a role, it's probably a kind of investment people don't see more than 5 to 15 percent in a portfolio. I don't think you want to put a lot of money into it but I think that investor who's looking at inflation, we've seen CPI start to firm with the last couple of months and you think inflation could be on the upswing. This is going to provide some protection in your portfolio against that potential increase in inflation.

Nate Geraci: Lastly, the iShares Floating Rate Bond ETF ticker FLOT, this holds investment grade floating rate notes. Can you briefly describe what these are and then where this ETF might fit in a portfolio?

Matt Tucker: FLOT is a fund invested in floating rate investment grade securities. A lot of investors when they hear floating rates they think about bank loans. Bank loans are high-yield securities for much riskier investors. FLOT, all the bonds come from investment grade companies, so the kind of typical high quota companies you might expect to see a bond issue from. These bond issues just happen to pay a coupon whose interest rate is tied to a short term rate, with a three month labor. All that means is that as short term interest rates increase, let's say the Fed is raising short term rates, if those rates were to rise. You would see the coupons on FLOT increase and if the Fed were to cut rates, the rates would move down you'd see those coupons decrease. If you look at the coupons on these bonds historically they've tracked very closely to where the Fed is and where the Fed sets the Fed funds rate. In terms of role in the portfolio, we really see two things, two potentials here. One is that if you are an investor who is concerned about rising interest rates, concerned about longer maturity bonds. This could be a way to hold some corporate bonds and yet not take as much interest rate risk or duration risk in your portfolio. The second thing is that this is one of the ways an investor could actually participate in a Fed increase. If you think the Fed is being more aggressive, that they're really pushing rates higher and you own FLOT you're going to see it's distributions are going to increase as the Fed is raising rates. It can be a way to actually ride the Fed move up. Tactically, I don't feel like this is really the market right now where something like FLOT makes a lot of sense for the more tactical investor. Just because, as I mentioned I don't think the Fed move is imminent, I think this could be a very interesting play as we move later in the year and as we get closer to Fed action. I think that at this point we're probably six months or so away from the Fed doing anything at the earliest. This may not be the best place to go right now, but it's something to think about down the road.

Nate Geraci: Matt, we'll have to leave it there. As always, fantastic insight into the bond market. We greatly appreciate you joining us on the program today. Thank you.

Matt Tucker: Thanks Nate.

Nate Geraci: That was Matt Tucker, head of iShares Fixed Income Strategy. You can learn all about the iShares line up of bond ETFs by visiting ishares.com. I would also mentioned that Matt authors an excellent blog on different bond topics, you can find that at blockrockblog.com