Even in an environment with low rates and high unpredictability, bond exchange-traded funds can serve the traditional roles of income and stability for investors. The trick is finding the right ETFs, said Gene Tannuzzo, deputy head of fixed income at Columbia Threadneedle Investments.
Instead of using passive ETFs supported by broad aggregate bond indexes, or going fully active with their fixed-income allocations, Tannuzzo argues that investors can find both ballast and income potential in multi-sector bond ETFs driven by so-called “strategic beta” indexes.
“Strategic beta designs a balance between credit and liquidity risk to create a more efficient total return,” said Tannuzzo. “It’s different from factor weighting.”
Columbia Threadneedle offers a pair of multi-sector bond ETFs based on strategic beta indexes: The Columbia Diversified Fixed Income Allocation ETF (DIAL) and the Columbia Multi-Sector Municipal Income ETF (MUST). But Tannuzzo, who also oversees a stable of active bond managers in his firm's mutual funds business, describes himself as agnostic regarding active versus passive.
Aggregate bond indexes, like the Bloomberg-Barclays U.S. Aggregate Bond Index, otherwise known as the Agg, fall short for bond investors in several ways, Tannuzz explained. But when it comes to income, it’s their allocation among the major asset classes and sectors of bonds that harms their performance.
“There are three asset classes in [the Agg],” he said. “U.S. government bonds, U.S. agency mortgage-backed securities and investment-grade corporate bonds, which are only 20% of the index. The other three quarters essentially align with government-backed assets that the Fed has made into a policy tool.”
With the Federal Reserve committed to long-term low interest rates and a policy of quantitative easing, funds based off the Agg aren’t likely to offer significant positive real yields to investors. Over the past several days, the yield of the Agg has hovered around 1.5%, said Tannuzzo, who noted that one of the prevailing measures of inflation, the PCE deflator, also comes in at around 1.5%. “After inflation, you get nothing.”
That’s important because the fixed-income market is situated in such a way that the major driver of investor returns will be yields, or the income offered by bonds, which means many fully passive aggregate fixed-income ETFs will offer nothing in the way of real returns.
“The two basic measures of value, Treasury interest rates and credit spreads, are both starting the year at pretty low levels and it’s harder for them to go lower [which would make prices higher],” said Tannuzzo. “The places where we might still see some price appreciation in the bond market, even though we’re starting from elevated prices, are areas that can still recover from specific Covid-19 impacts.”
That would include bonds related to travel and leisure, said Tannuzzo, who identified commercial mortgage-backed securities as a potential area of opportunity for fixed-income investors, as well as areas of the municipal bond markets related to hospitals, toll roads and retirement communities, which were negatively impacted by the pandemic.