Q&A: BlackRock’s Karen Schenone on Fixed Income Outlooks

While the stock market has been climbing despite the current state of the global economy, the fixed income market is faring less well. With interest rates bottoming out, the hunt for income without excessive risk is on. Do you try to cherry-pick individual bonds, or stick with bond funds despite fees making up a higher proportion of their lower return? And how long will these low rates persist?

For a clearer look at the outlook for the fixed income market, we spoke with Karen Schenone, managing director and head of iShares Fixed Income Strategy for USWA within BlackRock’s Global Fixed Income Group. She shares what may be in store for fixed income and where advisors can turn for income without taking on too much liquidity risk. Keep reading for excerpts from that interview.

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What is the fixed income outlook for the rest of 2020?

Following the extreme market volatility in the first half of 2020, global central banks cut interest rates, purchased bonds and set up special facilities to provide support to the financial markets and broader economy.

In the U.S., the Federal Reserve’s target rate was cut 1% in March and is now at a level of 0% to 0.25%. The Fed is not expected to raise interest rates over the next 18 months as they want to be accommodating for the economy to recover.

Longer-term interest rates are also expected to stay low as economic growth has stalled and inflation remains low. Credit risk for both corporate and municipal issuers remains heightened compared to January but has decreased relative to March and April.

Credit spreads on investment-grade bonds have declined to about 1.25%. Defaults have increased to 6.2% on a 12-month rolling basis as some companies faced lower revenues due to closures of certain segments of the economy. Defaults are expected to increase to about 8%, which is slightly below the high-water mark for the 2008-2009 credit cycle.

For investors, interest rates at incredibly low levels, this means rethinking how to boost income or how much interest rate risk should be in the portfolio. Fees and transaction costs on bonds also become a more important part of the equation. If bond yields are low, then investors cannot afford to pay too much in management fees. These factors have more and more investors turning to bond exchange-traded funds, which allow all investors to access specific parts of the bond market and lower the entry costs of investing.

[Read: Managing Portfolios: The Upside of Structured ETFs.]

How are advisors using bond ETFs in today’s environment?

At the end of 2019, U.S. households still held $5.2 trillion in individual bond portfolios, according to data from the U.S. Federal Reserve, but have been declining in the factor of managed vehicles, such as mutual funds, separately managed accounts (SMAs) and ETFs.

Bond ETFs are rapidly growing in usage as they offer an investment in bonds with the “tradeability” of stocks and can potentially help lower costs. The average bond ETF expense ratio is less than 0.2% with iShares Core U.S. Aggregate Bond ETF ( AGG) at just 0.04%, while the average mutual fund has an expense ratio of 0.66%, using data from Morningstar.

Bond ETFs have become an important tool for portfolio construction. Most bond ETFs are index funds that trade on the exchange, but some are actively managed.

Financial advisors are using ETFs to diversify equity market risk or potentially preserve capital. To diversify equity market risk, bond ETFs are a low-cost way to add fixed income exposure to a multiasset portfolio. For long-term investors, one of the main reasons to own bonds is a source of equity market diversification. Bonds used for this purpose should have low correlations to the stock market, which typically means U.S. government bonds or investment-grade exposures.

For investors who are more concerned with a return of investment, rather than return on investment, they can use short-maturity bond ETFs. Bonds with maturities of less than five years can provide some income with low levels of volatility. For example, iShares Ultra Short-Term Bond ETF ( ICSH) and iShares Short-Term Corporate Bond ETF ( IGSB) can help investors keep their money invested without taking on much risk.

[READ: Q&A: BlackRock Explains Megatrend ETFs.]

How has liquidity changed in the bond market? What can advisors do to manage liquidity risk?

Liquidity, which is the ability to sell an investment in a timely manner, has become a more important focus this year as market volatility increased. Individual bonds trade over-the-counter, and not every bond trades every day since many investors hold these investments to maturity. During the market sell-off in March and April, investors were faced with falling bond prices and a lack of liquidity. Many advisors needed to rebalance portfolios after stock prices fell, and that meant selling bonds to buy stocks. The market impact of selling individual bonds went from just a few basis points to percentage points as some investors were demanding liquidity at any cost. Even after calm was restored to the markets, transaction costs remain elevated. By contrast, bond ETF trading was orderly and efficient.

Some steps advisors can take include reviewing portfolios with an eye on liquidity risk. Think about the investor’s time horizon, rebalance frequency and cash flow needs. Advisors can create liquidity tiers by setting dollar amounts into short-term, near-term and longer-term buckets. (One strategy is) keeping the short-term allocations in liquidity investments like ETFs and then less liquid allocations in individual bonds, actively managed funds and even private investments.

Because bond ETFs trade on the stock exchange, they became important vehicles for price discovery and liquidity in 2020. Some investors are using bond ETFs as liquidity sleeves in bond portfolios. A liquidity sleeve is a holding or holdings in a portfolio that can help maintain market exposure or generate income but still be quickly sold and converted into cash. Given the wide range of bond ETFs available in the market, investors can select an ETF that invests in the same sector, such as corporates or municipals, to maintain a similar market exposure and/or tax treatment as their broader bond portfolio.

How can advisors implement a bond ladder strategy with ETFs?

A bond ladder is a strategy where investors buy bonds that mature each year over a set time horizon, such as a five- or 10-year period. The bonds are weighted equally across each maturity year. For example, 10% of the bonds maturing each year for 10 years. When a bond matures, the proceeds are used to buy a bond on the next rung on the ladder. Bond laddering is an effective strategy for managing reinvestment risk, but it can be difficult to implement with individual bonds. Credit research needs to be conducted, and bonds might get called early, which makes it necessary to find replacement bonds.

Advisors can implement a bond ladder strategy more efficiently with term-maturity ETFs, which solves some of the problems with buying individual bonds. Term-maturity ETFs, known as iBonds, are exchange-traded funds that mature like a bond, trade like a stock and are diversified like a mutual fund. These ETFs hold bonds that mature over a calendar year, and when the last bond matures, the fund will return the final net asset value, referred to as NAV, to its holders. The investor will then receive a cash payment into their account, just like a bond maturity. IBonds are now offered in U.S. Treasury, municipal, investment-grade and high-yield sectors, giving investors the opportunity to match the investment to their risk tolerance, tax considerations and income requirements.

With interest rates low, what are some ways that investors can add yield?

Since yields are low, investors should look for low-cost ways to invest in the markets as fees can quickly become a headwind to portfolio returns. Income will be a more important component of total return for fixed income portfolios, though it is important not to overreach and take on too much credit risk. Investment-grade corporate bonds such as iShares iBoxx $ Investment Grade Corporate Bond ETF ( LQD) and mortgages-backed securities iShares MBS ETF ( MBB) are high-quality ways to seek income.

For those investors that have higher risk tolerances or longer time periods, high-yield corporate bonds are a way to increase portfolio yield. Currently high-yield bonds are yielding about 5.3%, using data from Bloomberg Barclays US High Yield index as of Aug. 12. Other ways to seek income over 5% are with preferred stocks, which sit in between stocks and bonds in the capital structure, and emerging-market debt. ETFs such as iShares Broad USD High Yield Corporate Bond ETF ( USHY), iShares Preferred and Income Securities ETF ( PFF) and iShares JP Morgan USD Emerging Markets Bond ETF ( EMB) can help investors access these access classes in a low-cost manner.

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Q&A: BlackRock’s Karen Schenone on Fixed Income Outlooks originally appeared on usnews.com

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