At The Money: How Fixed-Income Investors can use ETFs to their Best Advantage.

Investors seeking yield were once required to purchase individual bonds or mutual funds. Today, investors can purchase low-cost bond ETFs in just about any flavor you can imagine. Steve Laipply is managing director at BlackRock and Global Head of iShares fixed income ETFs. Previously, he was the head of iShares fixed income strategy. He helps oversee more than a trillion dollars in fixed income assets. Each week, “At the Money” discusses an important topic in money management. From portfolio construction to taxes and cutting down on fees, join Barry Ritholtz to learn the best ways to put your money to work. See omnystudio.com/listener https://omnystudio.com/listener for privacy information.

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• 2:19Barry Ritholtz?

  Investors who are looking for yield were once required to purchase individual bonds or mutual funds. Today ETFs have changed the fixed income market just as surely as they've changed the equity markets. Investors can purchase low-cost bond ETFs in just about any flavor you can imagine. I'm Barry Ritholtz and on today's edition of At the Money, we're going to explain how fixed income investors can use ETFs to their best advantage. To help us unpack all of this and what it means for your portfolio, let's bring in Steve Lepley. He's Managing Director at BlackRock and Global Head of iShares Fixed Income ETFs.

• 3:04Barry Ritholtz?

  Previously, he was the Head of iShares Fixed Income Strategy. He helps to oversee more than a trillion dollars in fixed income assets. So Steve, let's just start simply, why ETFs? What are the advantages over bond separately managed accounts or mutual funds?

• 3:26Speaker 03

  Good to see you Barry. Thanks for having me. So this has been a bit of a journey that spans decades actually. And so to really understand the power of bond ETFs, you have to kind of go back before they existed. So let's call that, you know, kind of late 90s. The very first bond ETF came out in Canada in the year 2000 and then in the US in 2002. But if you go back to the 90s, buying bonds was a non-trivial exercise. And the way it was done, it was a very much voice-driven market. Pick up the phone, you call several people, you get several quotes, hoping the market's not moving on you at the same time.

• 4:06Speaker 03

  Not quite sure if you exactly got the best price. There was very little transparency, et cetera, et cetera, and kind of uneven access. So depending on who you were and what kind of wallet you had, you might get different treatment. And so... That was a problem for some investors, not for all. For investors who had access, you know, maybe they viewed that as an advantage. But for a lot of us, it was really challenging to build a high-quality diversified bond portfolio. So what do bond ETFs do? They actually opened that whole world up to transparency. You basically now had not even a single bond, but a portfolio of bonds that trade on exchange.

• 4:51Speaker 03

  You know what's in it. You could see the price on exchange every second ticking by. So you don't have to pick up the phone and call people. You just simply can trade on exchange and you know you're getting the best price that's quoted on exchange. Now, again, like anything, you have to use proper discipline when executing orders, et cetera. But it was just a shocking, revolutionary thing to be able to trade bonds on an exchange.

• 5:16Barry Ritholtz?

  So that makes a lot of sense. I remember when this market was very dealer-driven, but there was always an option, or at least over the past, let's call it 40 years, an option of bond mutual funds. There are obvious advantages for equity ETFs over equity mutual funds. How does that translate to fixed income ETFs? What are their advantages over fixed income mutual funds?

• 5:44Speaker 03

  Well, there are a couple. You know, mutual funds still play a role. You'll tend to see them in 401Ks and things like that. That's more of an architecture thing. But away from that, mutual funds price one time a day, at the end of the day, right? So you don't know in the middle of the day, really, what the valuation is. And so I think a lot of advisors and investors have found the idea of being able to trade intraday at a known price really attractive. Because as you can imagine, you know, Barry, let's just say you get, you know, a strong inflation number, or, you know, an employment report, or what have you, and you want to move on that.

• 6:26Speaker 03

  You could put in an order for your mutual fund and sure, that'll get filled at the end of the day. You really don't know at what value. Bond ETF, you can just go on exchange immediately and you can decide whether that's the right price or not and you can act on it. So there's that. The second part of it would just be the transparency issue. For mutual funds, you may have quarterly reporting or what have you as opposed to daily for most bond ETFs. And that includes active strategies. So a lot of investors are attracted that daily transparency as well.

• 6:58Barry Ritholtz?

  And there used to be, I don't know, tens of thousands of mutual funds out on the fixed income side. What sort of selection do ETFs present for bonds or fixed income in the exchange traded fund wrapper?

• 7:15Speaker 03

  Well, it's been exploding, particularly, I would say, since the ETF rule in 2019. And then also, you know, the pandemic and the subsequent policy responses, I think unleashed a whole new level of demand with the normalization in yields. But standing here today, I think we're over 1,000 bond ETFs in the United States alone. iShares has over 160 in the U.S. We have 1.3 trillion assets in the U.S. Or sorry, 900, over 900 billion in the U.S. and 1.3 trillion globally. But the selection is enormous now and it spans not just asset

• 7:54Speaker 03

  class, meaning treasuries, credit, high yield, emerging markets, et cetera. But also within a given asset class, you now have maturity cuts. You have outcome overlays on top of that. You have hedged products. So it's been very, very much built out and you also now have quite a lot of active strategies within those asset classes or sectors.

• 8:16Barry Ritholtz?

  One of the criticisms that the equity side of ETFs always get is, well, just wait till the next crash or period of stress, you'll see how poorly these perform. That didn't happen during the pandemic crash. And then we started hearing the same criticisms about fixed income ETFs. Just wait till a moment of stress. How did ETFs perform either in 2020 during COVID? And how did fixed income ETFs perform during the rate shock in 2022?

• 8:48Speaker 03

  Yeah, and this is what I think really garnered the next wave of adoption. Because over the years, if you go back to, you know, sort of the global financial crisis, they existed then, and we did have a lot of investors who were interested in them just because of this idea that, okay, during a crisis, I can see where things are trading on exchange, and okay, that's valuable, because now I can look at an investment-grade credit ETF like LQD or a high-yield ETF like HYG during the crisis and see what's happening, which is very hard to do if you remember back then. So the criticism was, well, they're small, they haven't been around that long, not really sure if I want to use them yet, I need to see them get larger and go through

• 9:32Speaker 03

  more stress tests, okay? So between the global financial crisis and 2020, there were kind of minor bumps here and there, but nothing severe. I think 2020, especially February, March, when even, you know, some treasuries and investment-grade were struggling to trade, I think that finally got people over the line, because at the worst of it, it was hard to trade off-the-run treasuries, it was hard to trade investment-grade, but ETFs, even though they may have been trading at a discount, were tradable, and they were trading in record volume. And I think that finally, finally got a lot of people over the hump. That was the test they were waiting for.

• 10:12Barry Ritholtz?

  And they definitely passed with flying colors.

• 10:15Speaker 03

  Yeah, and then the rate shock was just icing on the cake, you know, another stress episode, which further, I think, cemented investor confidence in the wrapper.

• 10:24Barry Ritholtz?

  So let's move beyond the structure of ETFs and start talking about fixed income investing in ETFs. Money markets are 3.6%, 3.7%, as we're recording this, yields went up a little bit today on non-farm payroll data, but, you know, you're not that far off from 4%, pretty competitive with the middle of the curve for bond yields. Why should investors think about rolling out of money markets and into bond ETFs in this rate environment?

• 10:58Speaker 03

  And this is the question, and I think it doesn't have to be a binary choice, right? So what we've been saying is that, you know, if you think about what sort of happened with views on the Fed over the last, you know, call it six months, it's changed a lot, right? We went from having some cuts priced in, now we've got, you know, as we're standing here today, now we have a full hike priced in by the end of the year. We have another one priced in for next year, maybe more. And that could change just as rapidly going the other way. And so it's really less about, you know, trying to time or finesse this and more about just diversifying. So sure, you're going to be able to earn decent carry in your money market account

• 11:42Speaker 03

  right now, but as a diversifier, what we've been saying is take at least some of that, step out on the curve, you know, let's call it intermediate, you know, maybe three to seven years, something like that. Because in the event that things do change, for example, the geopolitical picture could change very, very rapidly, you could get sort of oil prices receding, inflation kind of coming back down, et cetera. That will get us back off to the races the other direction. And you know what's really funny, Barry? If you look at the 10-year yield over the last three years, it kind of looks like a sine wave. You've been, you know, 360, up to five and everywhere in between, over and over and over again. And so it's very, very hard to time this, right?

• 12:24Speaker 03

  So just don't put all your eggs in one basket, have your bets, you know, sort of spread out on the curve, because you never know how fast it'll change.

• 12:32Barry Ritholtz?

  Yeah, it's kind of fascinating talking about the reversals. How long were we waiting for the Fed to start cutting? And it seemed like it took years and years of people being wrong. And now we're reversing, not only reversing the idea of cuts, but given the war, given what's going on in inflation, it's amazing that it took such a short period of time to price in two hikes. But given where we are in the Fed cycle, I don't even want to say cutting cycle, what does this lack of clarity mean for fixed income investors? How should they think about, are we cutting? Are we raising? Are we going into recession? Are we not going into recession? It seems like it's been a specially confusing period.

• 13:19Speaker 03

  Yeah, and this is what's really fascinating to watch is that investors, very interestingly, just based on the flows, you know, we're having record flows, you know, yet again this year, and that's on top of records of prior several years, we are seeing investors kind of look through this volatility. And so far, you know, I want to say that we're up somewhere around 20 to 30% relative to last year. So investors don't seem to be too concerned by the dramatically, you know, kind of changing landscape here. What they are focused on is the income opportunity. So the majority of fixed income assets are now yielding above

• 13:59Speaker 03

  4%. That was not the case. I think it was something like 20% before the pandemic, between the crisis and the pandemic. And so investors are actually looking at this as an opportunity where they can now earn income in fixed income for the first time in many years. And they're very focused on that as opposed to just, you know, the 10-year, whether it's at 4% or 5%. They're focused on the income. And so that's how they're allocating.

• 14:24Barry Ritholtz?

  So we're talking a little bit about inflation. I would be remiss if I didn't bring up the iShares TIPS ETF. Our clients are owners of this. They've done really well over the past couple of years. Tell us a little bit about why people should think about having a TIPS bond ETF in their portfolio.

• 14:45Speaker 03

  Yeah, and it's proven to be really, really powerful because it was not expected. Everybody had pronounced inflation dead. We saw it come roaring back. And then there was the idea of very strong policy response to rein it back in. Now we've gotten a supply shock in energy, which has sort of, you know, thrown things a little bit in doubt again. And so it goes, you know, to the point that you should have a resilient portfolio. And that resilience, some of which has to be anchored in trying to protect against inflation. And so it's up to the investor to decide how much or how little they want to lean into that. And so you can buy individual TIPS bond ETFs like STIP or TIP.

• 15:29Speaker 03

  We even have a shorter one, which is one year called ICPI, if you really want to just peg inflation itself. But I think other exposures are now incorporating it. So, you know, we just, we just launched late last year, a broader bond ETF. So you think of the ag, the universal, we have something called the total, which is B T O T. That includes an inflation component. So the ag and the universal don't have that. This one does. And that is a nod to the idea that going forward, you probably want to have some protection against inflation. It'll wax and wane, but I think, you know, it, it shows you now that it's necessary.

• 16:08Barry Ritholtz?

  So tips are one sort of opportunity that's in the fixed income ETF area today. What other areas are attractive? Do you like investment grade corporates, high yield, munis, even agency mortgages and active bond ETFs? What, what do you see the greatest opportunity set in, in the world of ETFs and fixed income?

• 16:29Speaker 03

  So let's do that in two steps. I think overall, you know, I think you want to be in sort of that high quality tilt. Right? For many investors, that is, that is a comfortable thing from a risk profile standpoint. So getting back to the two dimensions here, credit and duration. So credit, we've, we've seen the flows go mostly into very high quality. So think treasuries, investment grade, et cetera. But also kind of that intermediate duration component as opposed to being much longer in the curve. So investors are sort of anchoring on high quality, intermediate duration. Away from that, what, what also has been getting a lot of interest, you know, going back to the income theme?

• 17:12Speaker 03

  Investors really like what we're calling these plus sectors. And what that means is, okay, outside of treasuries and investment grade, what do you have? Yeah, you have high yield in emerging markets. That may not suit all investors, but you also have things like securitized assets, which offer, you know, a pretty attractive income profile relative to, relative to their duration risk, et cetera. And so, you know, think of that as. Mortgages are one part of that, but then you can also have asset-backed securities, commercial mortgage-backed securities, things like that. So securitized assets have been really popular as well. On the active side, as you know, Rick Reeder launched a multi-sector income ETF called BINC Bank

• 17:57Speaker 03

  that has exposure to a lot of those plus sectors. And that fund has proven to be enormously popular, again, that income theme without taking outsized risk. And so it's that sort of general theme, let's lean into income, de-emphasize duration, not take a huge amount of credit risk. I think that sort of captures a lot of what we're seeing investor interest in.

• 18:20Barry Ritholtz?

  Last question, how should investors be thinking about the fact that we have a new FOMC Chair in Kevin Warsh? What does that mean in terms of thoughts about duration, especially given how hawkish so many members of the committee are? And how publicly he stated he's interested in Fed cuts?

• 18:44Speaker 03

  Well, and this gets to something we've talked about in the past, Barry, which is, you know, the market itself has already priced in what it thinks will happen. So the real question is less about who's, you know, at the head of the Fed right now, and more about if you look at where the market's pricing Fed action. Meaning, we talked about this earlier in the conversation. We went from cuts to, you know, a high price in this year and maybe more next year. Do you, as an investor, believe that, right? And that's the question, because if you look at the futures contracts, or if you look at the shape of the yield curve, you have to make up your mind, do you believe that or not? If you don't believe it, you know, are you more hawkish than that? Are you more worried about inflation than that? You may want to rein in your duration risk.

• 19:29Speaker 03

  If you think that none of that's going to materialize, and then you could even go back to cuts, you may want to move out further in the curve. However, for many investors, if you don't even want to try to call that, again, just be diversified, right? So, you know, maybe just sort of anchor in the middle part of the curve, the intermediate duration. Don't go all the way to the short end, don't go all the way to the long end. You don't really know how this is all going to play out, and most investors aren't really interested in trying to predict that. So just get your exposure, lean into income, and then just, you know, be patient.

• 20:06Barry Ritholtz?

  So to wrap up, investors who want some fixed income exposure have a variety of choices today that they didn't have just as recently as five years ago. It doesn't matter if it's mortgage-backed, inflation-hedged, global ag, domestic, whatever you want in terms of exposure to fixed income, you can get that through bond ETFs. I'm Barry Ritholtz, you're listening to Bloomberg's At the Money.

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