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Hunt for answer to bond blues turns to active ETFs

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The crushing of global interest rates to historically low levels has delivered big gains for bond investors and crowns a four-decade run of solid returns. From here, the picture looks tougher and that may mean investors need to take a more active approach to managing their portfolios.

A universe where bonds provide little to no interest fails in providing a fixed income beyond the current rate of inflation. It also limits the prospect of capital appreciation for portfolios. And that’s the good news. Far more daunting is the likelihood that investment in government and other high-quality bonds over time registers negative returns once the global economy negotiates the pandemic.

Sure, central banks will try to limit a sharp rise in yields on bonds, but a potentially more inflationary future explains why many current investment strategists favour a greater shift towards owning equities, commodities and alternative assets such as infrastructure. Plenty think bond returns are set for a repeat of their modest run returns in the decades before 1981. Returns fell in real terms during the postwar period, hurt by a combination of yields being low and rising inflation.

That does not mean investors can, or will, turn their backs on fixed income, which in the US constitutes a $45tn market of outstanding debt, and continues growing. Investment mandates in bonds are well-established and, more importantly, there are ways to mitigate the pain of low yields given the diverse and broad scope of fixed income instruments.

Line chart of Return on US 10-year Treasury, adjusted for CPI inflation (index, 1927 = 100) showing A four decade boom for bond investors

While a company trades under one equity market listing, bonds are a more diverse story. Debt is sold with different maturities and yields and across a variety of sectors. These range from sovereign borrowers and corporations to the bundling of mortgages, car loans and credit cards, among others. That provides a savvy bond investor with a broad menu to help them navigate swings in market interest rates and the economy.

Into this mix comes the rise of an unlikely product: exchange traded funds for bonds, a low-cost way to invest in a basket of assets by tracking an index. This could have a big impact.

At the recent Morningstar Investment Conference, BlackRock chief executive Larry Fink said: “We’re seeing more and more active investors using ETFs for active management. They go in and out of passive exposures through ETFs, and the biggest transformation of that is in fixed income. The fixed income market will be substantially more of an ETF market in the future.”

In recent years, more money has been flowing into ETFs that track various baskets of US bonds than equities. The process of buying and selling an ETF is smoother and faster than transacting in cash bonds and that has transformed fixed income trading in recent years.

Currently, actively managed bond ETFs represent nearly one-tenth of the $1tn market, according to ETF.com. Among net inflows this year of $152bn into fixed income ETFs, 13.4 per cent — or $20.4bn — has been garnered by the actively managed bond sector.

Line chart of Cumulative estimated net flows into fixed-income ETFs ($bn) showing Record pace for bond ETFs

When market turmoil hit in March, as Covid-19 started to spread, corporate credit ETFs were quicker to reflect the downward pressure on prices compared with cash bonds. As part of its measures to steady financial markets, the US Federal Reserve announced that it would buy investment-grade credit ETFs. The backing of the central bank and better financial market conditions have spurred record inflows into bond ETFs for the year to date and robust returns. 

But now that the juice has been squeezed from bonds and driven yields towards the floor, the case for looking at actively managed fixed income ETFs has renewed impetus.

“The near-zero yield environment has awakened investors,” said Jerome Schneider, head of short-term portfolio management and funding at Pimco. Among the benefits of active ETFs is the “ability to maintain diversification and a freedom to pick sectors such as structured products and mortgages”. “You are trading a bit more and relying less on a buy-and-hold approach,” he says.

An unappreciated aspect of a bond index is that hefty levels of debt belonging to one sector or company have a heavier weighting in the benchmark. Mark Dowding, chief investment officer at BlueBay Asset Management, says: Passively tracking a flawed benchmark offering ultra-low yields is just less attractive than it once was.”

At Wisdom Tree, the fixed income ETF, the AGGY, largely tracks the leading broad US bond index, which is dominated by government bonds. However, it boosts the weighting of smaller sectors beyond Treasuries in order to generate higher returns.

Expect a growing menu of actively managed ETFs in a yield-constrained world as more investors toggle in and out of bonds. And while advocates of a more active approach in fixed income are talking a good game and make a reasoned case, they need to demonstrate their prowess in the coming years. When rates are so low, investors are counting on finding strategies that beat simply sticking with an index.

michael.mackenzie@ft.com



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Gensler raises concern about market influence of Citadel Securities

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Gary Gensler, new chair of the Securities and Exchange Commission, has expressed concern about the prominent role Citadel Securities and other big trading firms are playing in US equity markets, warning that “healthy competition” could be at risk.

In testimony released ahead of his appearance before the House financial services committee on Thursday, Gensler said he had directed his staff to look into whether policies were needed to deal with the small number of market makers that are taking a growing share of retail trading volume.

“One firm, Citadel Securities, has publicly stated that it executes about 47 per cent of all retail volume. In January, two firms executed more volume than all but one exchange, Nasdaq,” Gensler said.

“History and economics tell us that when markets are concentrated, those firms with the greatest market share tend to have the ability to profit from that concentration,” he said. “Market concentration can also lead to fragility, deter healthy competition, and limit innovation.”

Gensler is scheduled to appear at the third hearing into the explosive trading in GameStop and other so-called meme stocks in January.

Trading volumes in the US surged that month as retail investors flocked into markets, prompting brokers such as Robinhood to introduce trading restrictions that angered investors and drew the attention of lawmakers.

The market activity galvanised policymakers in Washington and investors. Lawmakers have focused much of their attention on “payment for order flow”, in which brokers such as Robinhood are paid to route orders to market makers like Citadel Securities and Virtu.

That practice has been a boon for brokers. It generated nearly $1bn for Robinhood, Charles Schwab and ETrade in the first quarter, according to Piper Sandler.

Gensler noted that other countries, including the UK and Canada, do not allow payment for order flow.

“Higher volumes of trades generate more payments for order flow,” he said. “This brings to mind a number of questions: do broker-dealers have inherent conflicts of interest? If so, are customers getting best execution in the context of that conflict?”

Gensler also said he had directed his staff to consider recommendations for greater disclosure on total return swaps, the derivatives used by the family office Archegos. The vehicle, run by the trader Bill Hwang, collapsed in March after several concentrated bets moved against the group, and banks have sustained more than $10bn of losses as a result.

Market watchdogs have expressed concerns that regulators had little or no view of the huge trades being made by Archegos.

“Whenever there are major market events, it’s a good idea to consider what risks they might have placed on the entire financial system, even when the system holds,” Gensler said.

“Issues of concentration, whether among market makers or brokers at the clearinghouse, may increase potential system-wide risks, should any single incumbent with significant size or market share fail.”



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European markets recover after tech stock fall

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European equities rebounded from falls in the previous session, when fears of a US interest rate rise sent shares tumbling in a broad decline led by technology stocks.

The Stoxx 600 index gained 1.3 per cent in early dealings, almost erasing losses incurred on Tuesday. The UK’s FTSE 100 gained 1 per cent.

Treasury secretary Janet Yellen said at an event on Tuesday that rock-bottom US interest rates might have to rise to stop the rapidly recovering economy overheating, causing markets to fall.

Yellen then clarified her remarks later in the day, saying she did not think there was “going to be an inflationary problem” and that she appreciated the independence of the US central bank.

Investors had also banked gains from technology shares on Tuesday, after a strong run of quarterly results from the sector underscored how it had benefited from coronavirus lockdowns. Apple fell by 3.5 per cent, the most since January, losing another 0.2 per cent in after-hours trading.

Didier Rabattu, head of equities at Lombard Odier, said that while investors were cooling on the tech sector, a rebound in global growth at the same time as the cost of capital remained ultra-low would continue to support stock markets in general.

“I’m seeing a healthy correction [in tech] and people taking their profits,” he said. “Investors want to be much more exposed to reflation and the reopening trades, so they are getting out of lockdown stocks and into companies that benefit from normal life resuming.”

Basic materials and energy businesses were the best performers on the Stoxx on Tuesday morning, while investors continued to sell out of pandemic winners such as online food providers Delivery Hero and HelloFresh.

Futures markets signalled technology shares were unlikely to recover when New York trading begins on Wednesday. Contracts that bet on the direction of the top 100 stocks on the technology and growth-focused Nasdaq Composite added 0.2 per cent.

Those on the broader S&P 500 index, which also has a large concentration of tech shares, gained 0.3 per cent.

Franziska Palmas, of Capital Economics, argued that European stock markets would probably do better than the US counterparts this year as eurozone governments expand their vaccination drives.

“While a lot of good news on the economy appears to be already discounted in the US, we suspect this may not be the case in the eurozone,” she said.

Brent crude, the international oil benchmark, was on course for its third day of gains, adding 0.7 per cent to $69.34 a barrel.

Despite surging coronavirus infections in India, the world’s third-largest oil importer, “oil prices have moved higher on growing vaccination numbers in developed markets”, said Bank of America commodity strategist Francisco Blanch.

Government debt markets were subdued on Wednesday morning as investors weighed up Yellen’s comments with a pledge last week by Federal Reserve chair Jay Powell that the central bank was a long way from withdrawing its support for financial markets.

The yield on the 10-year US Treasury bond, which moves inversely to its price, added 0.01 of a percentage point to 1.605 per cent.

The dollar, as measured against a basket of trading partners’ currencies, gained 0.2 per cent to its strongest in almost a month.

The euro lost 0.2 per cent against the dollar to purchase $1.199.



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Yellen says rates may have to rise to prevent ‘overheating’

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US Treasury secretary Janet Yellen warned on Tuesday that interest rates may need to rise to keep the US economy from overheating, comments that exacerbated a sell-off in technology stocks.

The former Federal Reserve chair made the remarks in the context of the Biden administration’s plans for $4tn of infrastructure and welfare spending, on top of several rounds of economic stimulus because of the pandemic.

“It may be that interest rates will have to rise somewhat to make sure that our economy doesn’t overheat, even though the additional spending is relatively small relative to the size of the economy,” she said at an event hosted by The Atlantic magazine.

“So it could cause some very modest increases in interest rates to get that reallocation. But these are investments our economy needs to be competitive and to be productive.”

Investors and economists have been hotly debating whether the trillions of dollars of extra federal spending, combined with the rapid vaccination rollout, will cause a jolt of inflation. The debate comes as stimulus cheques sent to consumers contribute to a market rally that has lifted equities to record levels.

Jay Powell, the Fed chair, has said that he believes inflation will only be “transitory”; the central bank has promised to stick firmly to an ultra-loose monetary policy until substantially more progress has been made in the economic recovery.

The possibility of interest rates rising has been a risk flagged by many investors since Joe Biden’s US presidential victory, even as markets have continued to rally.

Yellen’s comments added extra pressure to shares of high-growth companies, whose future earnings look relatively less valuable when rates are higher and which had already fallen sharply early in Tuesday’s trading session. The tech-heavy Nasdaq Composite was down 2.8 per cent at noon in New York, while the benchmark S&P 500 was 1.4 per cent lower.

Market interest rates, however, were little changed after the remarks, with the yield on the 10-year Treasury at 1.59 per cent. Yellen recently insisted that the US stimulus bill and plans for more massive government investment in the economy were unlikely to trigger an unhealthy jump in inflation. The US treasury secretary also expressed confidence that if inflation were to rise more persistently than expected, the Federal Reserve had the “tools” to deal with it.

Treasury secretaries generally do not opine on specific monetary policy actions, which are the purview of the Fed. The Fed chair generally refrains from commenting on US policy towards the dollar, which is considered the prerogative of the Treasury secretary.

Yellen’s comments at the Atlantic event were taped on Monday — and she used the opportunity to make the case that Biden’s spending plans would address structural deficiencies that have afflicted the US economy for a long time.

Biden plans to pump more government investment into infrastructure, child care spending, manufacturing subsidies and green energy, to tackle a swath of issues ranging from climate change to income and racial disparities.

“We’ve gone for way too long letting long-term problems fester in our economy,” she said.



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