ETF Expert Corner

VanEck’s Ed Lopez Discusses Rising Rate Hedges, Crypto Indices

March 13th, 2018 by ETF Store Staff

Ed Lopez, Head of ETF Product at VanEck, offers his perspective on rising interest rate hedges, including spotlighting the VanEck Vectors Investment Grade Floating Rate ETF (FLTR) and the VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL).  Ed also discusses VanEck’s recent efforts surrounding cryptocurrency indices.



Transcript

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

Nate Geraci: Our guest today is Ed Lopez, Head of ETF Product at VanEck. VanEck is a top 10 ETF provider. They currently offer nearly 60 ETFs with over $35 billion invested in those ETFs. As we were discussing in the first segment, rising interest rates are becoming a greater concern for investors, particularly on the bond side of the equation, and so the focus of our conversation with Ed today will be on how you might combat rising interest rates in your portfolio. Ed is joining us via phone from New York. Ed, our pleasure to have you on the program.

Ed Lopez: Thanks. Happy to be here.

Nate Geraci: Ed, first I would just love to get your take on the current rate environment. Clearly, we've seen rates begin to pop a bit, especially since the beginning of the year. Obviously, nobody has a crystal ball, but do you think we're at some sort of an inflection point where perhaps we are entering a different rate regime than we've seen in some time?

Ed Lopez: Yeah, definitely. That's something that we've been talking about since we put our outlook out in January. VanEck’s base case for interest rates is that the 10 year goes to three and a half percent. And that's predicated on global growth, improving economies generally, and the QE unwind - this kind of unprecedented experiment that we've been in for the last decade or so - that that's happening as well. And so we're expecting rates to rise, and I think the combination of the fact that the US is trying to normalize rates while also trying to unwind QE means the implications for investors, they need to look for diversification. Either shorten duration, or diversifying away from US monetary policy.

Nate Geraci: Ed, on that note, just holistically, how do you think investors should think about hedges in their portfolio if higher rates are expected? Because I personally don't believe investors should attempt to make tactical interest rate calls, but clearly you also don't want to be caught flat footed. So how can investors find the right balance here?

Ed Lopez: I think it's kind of a matter of probabilities - whether you think the risk is greater to the upside or downside, or the risk is greater for rising interest rates than not. But generally, we would take a measured, diversified approach and we would look at it in terms of what your goal is and in terms of what income you’re trying to strive for. There are different ways of navigating rising interest rates. One could be reducing duration and shorter term strategies, or floating rate strategies, seeking value in credit, such as high yield, using that cushion of high yield to help offset some duration changes. And as I mentioned earlier, diversifying away from anything that has direct impact from monetary policy of developed markets, or US markets here in general.

Nate Geraci: Well, let's talk about a few of the ETF options from VanEck to potentially combat rising interest rates and you mentioned floating rate notes. I thought we might start with the VanEck Vectors Investment Grade Floating Rate ETF, ticker symbol FLTR. Take us through this ETF and why it can serve as a good hedge in a rising interest rate environment.

Ed Lopez: Yeah, certainly. The investment grade floating rate note ETF holds investment grade, corporate floating rate bonds. They're US dollar denominated. Most of this portfolio, or most of the issuers in this space, tend to be financials like Morgan Stanley, Goldman Sachs. But there are also other corporations like AT&T, Verizon. What's really interesting about this strategy, or looking at floating rate notes, is their coupons will reset on a quarterly basis, generally. And the coupon payments are tied to LIBOR. So they're typically say LIBOR, three month LIBOR, plus 25 basis points. Or three month LIBOR, plus 100 basis points, kind of depending on the credit quality of the issuer. And what that does, because of that reset, that allows the duration, the interest rate exposure to be very, very low. I think it's .16 in our case currently. So what's interesting about FLTR, we launched this in 2011, and I think it's probably one of the first smart beta ETFs, if I can call it that, in the sense that it's not truly market cap weighted, but it's modified. And one of the things that we do with the index for this fund is we look at the market for what it is, and take into account that it has this floating rate feature, and we break the market into three maturity buckets. So the longest third would get 66% of the weight in the portfolio, the middle third would get 22%, and the shortest third would get 12%. What this allows the index to do and the fund to do is to offer higher yields, but because of that coupon reset and the floating rate notes, it doesn't really affect the interest rate duration of the ETF or the exposure that you get. So that's kind of the really neat special sauce of that. The drawback in that, and it's a modest drawback if you think that the economy is improving and rates will be rising, is that that structure does increase the spread duration, so it gives a little bit more credit risk.

Jason Lank: Ed, this is Jason Lank. When investors consider floating rate products, obviously the duration component gets most of the attention. That's one of the real positive aspects. This is an investment grade product. Does that mitigate much of the investment risk?

Ed Lopez: Well, I guess there's different types of investment risk, whether you get your credit risk, your duration risk, spread risk. It helps improve the positioning relative to say something like maybe bank loans or something, which tend not to be investment grade. And so I guess you got to look at it in relation to other things. As I mentioned, it is investment grade, which I think helps improve its positioning as kind of almost a cash substitute in your portfolio, or secondary cash if you will. But it does have some credit exposure risk, given that these are corporate bonds and slightly weighted with the maturity bias.

Nate Geraci: Ed, as I'm sure you're aware, there are some other ETFs on the market covering investment grade floating rate notes. And you mentioned sort of the smart beta aspect to this particular ETF. Are there any other differences that you might highlight with FLTR?

Ed Lopez: Well, one of the results of the weighting scheme that we have is that it tends to offer 20 to 30 basis points higher yield, generally. But also, what we've noticed is that FLTR is purely corporate. It doesn't have any governments or supras in it. So I think that's something also that sets it apart.

Nate Geraci: And Ed, before we move on here, what's the downside to owning floating rate notes?

Ed Lopez: Well, the downside in this space, depending on what you're looking for, it's low yielding. I mean, relative to other fixed income products that you can get, but it's about two percent or so. A yield to worst of 2.6. But for the floating rate space, it's very competitive in its space. As I mentioned with its maturity weighting, or its bias to longer maturities, it has a slightly higher exposure to credit risk and spread duration.

Nate Geraci: Our guest today is Ed Lopez, Head of ETF Product at VanEck. Ed, another ETF I wanted to ask you about was the VanEck Vectors Fallen Angel High Yield Bond ETF, ticker symbol ANGL – great ticker symbol, by the way. And this ETF actually won ETF.com's ETF of the year last year. Can you explain for us what this ETF does and do you see this as potentially a good option in a rising rate environment?

Ed Lopez: ANGL's one of my favorite ETFs, probably because it was my idea. But it really plays on an anomaly in the market which has proven itself out over time. And what ANGL does is it invests in bonds that have been downgraded, but these are bonds that were originally issued as investment grade bonds. So these tend to be larger companies, brand names. You got SoftBank, EMC, Freeport McMoran are in there currently. So what you end up having is a high yield ETF or portfolio that tends to be higher credit quality. A lot of these, as they've gotten downgraded, will end up in the top rung of the high yield spectrum in the BB space. But the really interesting part of this is the market sees these downgrades coming, and they start to sell them off, and you have investment grade portfolio managers out there with their investment mandates, and when the bond gets downgraded, they have to sell it. And that creates a dislocation in the market that ANGL can then come pick up these high yield bonds, these newly high yield bonds, at a relatively good price. So it's a good value play in high yield.

Nate Geraci: And Ed, in terms of potentially using this in a rising rate environment, is it that extra yield cushion that ANGL provides that can make it a good holding, or are there some other features here?

Ed Lopez: Well, I think high yield in general, broad-based, or ANGL, the high yield cushion can provide that cushion, that extra premium of high yield, can provide a little bit of extra cushion to any duration effects. I will say that the credit spread today is a little lower than it has been in the last couple years. There's a little bit of cushion, but it is a little bit more sensitive to duration or interest rate rises than it has been in the last couple years. ANGL, if you compare ANGL to the broad-based high yield market, as I mentioned, it tends to have a higher credit quality, which may also help cushion any unforeseen drawdowns that might happen. And so again, it's a higher quality high yield. I think that's an interesting play.

Jason Lank: Ed, I noticed that FLTR, the floating rate fund, is fairly concentrated from a sector standpoint in financial, but ANGL seems to be much more diverse. Where do you see opportunities by sector? Is it cyclical in nature? Do you see any trends of where these opportunities come out?

Ed Lopez: It's interesting, with ANGL, it tends to be kind of a lagging indicator of the economy. A couple years ago, before oil prices collapsed, we were light relative to the broad, high yield market in energy and materials. As oil prices came down and a lot of these names started getting downgraded, they became a bigger part of our portfolio. Currently, I think there's some 24% allocated to energy, so it's got an overweight compared to the broad, high yield market. Last year, that really helped us. And so it tends to go where the economy has been, which again, kind of plays into its value play as a strategy. It is a little more diversified than FLTR, as you mentioned. And it has a number of different sectors. The biggest sectors right now are energy and materials.

Nate Geraci: Again, our guest is Ed Lopez, Head of ETF Product at VanEck. Ed, if an investor is concerned about rising rates, obviously they can shorten duration, as we talked about. They can look at floating rate notes. Maybe take on some credit risk through something like ANGL. Are there any other areas or VanEck ETFs you would highlight that you think offer some protection against rising rates?

Ed Lopez: One ETF that some folks have been really interested in is our Business Development Company ETF, or BIZD. It invests in a portfolio of these business development companies which are a kind of investment company that focuses on investing or lending to middle market private companies. They're kind of stepping in for where a lot of the banks have stepped out. What's interesting about them is their portfolio of loans, if you will, and investments, tend to be floating rate in nature. So I think on average, the portfolio of companies in BIZD have about 84% floating rate loan exposure. So one could surmise that as interest rates rise, the income they receive from their loans should go up. So that's been an interesting play for some investors looking for yield with a little bit more equity exposure as well.

Jason Lank: Ed, more of a general question. There are pundits that speak to the potential liquidity mismatches, particularly in the high yield space where the underlying high yield bonds may not be as liquid as the ETF that trades, and there might be some dislocation in a market disruption environment. Do you have any thoughts on that?

Ed Lopez: ETFs, even the high yield ETFs, have traded very well in historical periods of distress. I think ETFs actually offer another avenue of liquidity that the marketplace doesn't have. In many cases, you'll see it probably first in the ETF because of the nature of the way the underlying bonds trade, but the way the ETF is trading is probably more a reflection of where the actual value of the bonds are.

Jason Lank: And then lastly, Ed, another general question. You mentioned that VanEck's base case, at least moving into 2018 for the 10 year, was around three and a half percent. Do you have any thoughts on the long end of the curve? The Fed can exert quite a bit of influence on the short end, but lesser so on the end, say the 30 year. Any thoughts out that far?

Ed Lopez: That's tough to say. I think one of the X-factors there is how the unwind of quantitative easing goes. That might influence that. If it gets a little bit unruly, that could really influence the longer end. And, of course, there's a lot of noise in the market right now. A lot of potential geopolitical risk, whether it's Brexit, or tariffs, or what have you, that might have an impact on the economy if it doesn't get under control.

Nate Geraci: Ed, in terms of potential ETF options to hedge, what about just avoiding the US yield curve altogether? Maybe looking to emerging market bonds?

Ed Lopez: Yes, that's one area that we've also been talking about for a few years now. Our second largest ETF, it's kind of hard to believe, being known as a natural resource company, is our Emerging Market Local Currency Bond ETF. It tracks an index from JP Morgan, which is the benchmark for emerging market bonds. And it will hold local currency denominated bonds from a number of different countries. What we believe is that emerging market economies are also growing, they're benefiting from the structural global growth. They are independent of the Fed, and can make their own decisions in terms of their own monetary policy, and it provides a hedge, or a diversification away from US policy, as well as higher absolute rates, interest rates or yield. So if you look at the last month or so, you saw that along with some dollar weakness, you saw some outflows of emerging market dollar denominated bonds. But local currencies still held up.

Nate Geraci: Alright, Ed, lastly - we have just a few minutes left here - on an entirely different subject, I have to ask you about bitcoin and other cryptocurrencies. We've actually spent quite a bit of time covering this topic on our program and I know that last year, VanEck filed for the VanEck Vectors Bitcoin Strategy ETF. That application has since been withdrawn based on the SEC's response, as were a number of other bitcoin ETF filings. I know you probably can't speak directly to VanEck's particular filing, but I'd just love to hear your thoughts on the potential for bitcoin ETFs and maybe how VanEck views the crypto space as a whole?

Ed Lopez: Yeah, everybody's crazy for crypto these days. But I think in terms of a registered product here in the US, we might be a little bit of a ways from a bitcoin ETF, or something similar. But one of the areas that we are working on is trying to benchmark that space in general. And we have a subsidiary, an index subsidiary based in Frankfurt, our MV Index Solutions, which has created a series of indexes tracking some of the top digital assets. We actually call this space “digital assets” as opposed to “cryptocurrencies”. And what we really find, what we're really excited about, regardless of if we end up having a registered product or not, is the potential for the underlying technology, the blockchain - the potential for disruption and it to be a really transformative type of technology. And as we consider ourselves forward-thinking and kind of on the edge of what's happening in the market, we want to be there. We want to be able to provide insight into that space.

Nate Geraci: Ed, from an investor's standpoint, and I guess this is sort of broad, open-ended question, but how might they view the role of digital assets in a portfolio as the space evolves?

Ed Lopez: Yeah, we've been talking to a lot of advisors about this as well. And the way we've been talking about it is almost like venture cap. These digital assets are like little tech companies, and right now, you don't know which one's going to win. There's a lot of different technologies out there, some for different applications, and we would take a diversified approach is one of the ways that we've been talking about and one of the reasons why we launched the digital assets, multi-digital asset indexes. But we would look at it from a diversified standpoint and maybe a small sliver of your portfolio if you really had to have exposure to it.

Nate Geraci: Well, Ed, with that, we'll have to leave it there. Really appreciate you joining us on the program today and we certainly hope to visit again down the road. Thank you.

Ed Lopez: Thank you very much.

Nate Geraci: That was Ed Lopez, Head of ETF Product at VanEck, and you can learn more about VanEck's ETF lineup by visiting VanEck.com.