Fixed income exchange-traded funds (ETFs) saw a record $126 billion of inflows in 2017, bringing the overall market to nearly $600 billion. The majority of these flows, as well as existing assets under management, are in passive bond ETFs. But are passive, index-tracking approaches the best way to harness the fixed income opportunity set?
As we discussed in a recent paper, research presents compelling evidence that bonds are different from equities when it comes to the active-versus-passive debate. And breaking down the key components of the Bloomberg Barclays U.S. Aggregate Bond Index (BBAG) – the benchmark for many passive core bond ETFs – reveals several potential drawbacks in a passive investment approach. A well-designed active strategy like the one behind PIMCO’s Active Bond Exchange-Traded Fund (BOND) seeks to take advantage of some key opportunities not available with passive solutions that may lead to better outcomes for investors. PIMCO is a leader in active ETFs, with over $10 billion in active ETF assets under management and the largest actively managed fund, the PIMCO Enhanced Short Maturity Active ETF (MINT), launched in 2009.
Evolution of the index: more risk for less reward?
Before delving into the three main components of the BBAG index – namely U.S. Treasuries, agency mortgage-backed securities (MBS) and investment grade (IG) corporate bonds – let’s look at some high-level statistics.
Duration, the primary risk factor for investors in high quality bonds, averaged six years for the BBAG in December 2017, up from 4.4 years at the end of 2007 (see Figure 1). This means investors trying to mirror the index have passively extended their duration by more than 35% since before the financial crisis! Why did duration increase so much? Primarily because borrowers (namely the U.S. Treasury, U.S. households with mortgages and U.S. corporations) have extended their liabilities to lock in current low interest rates. Bear in mind that you, the investor, are the one lending to these borrowers. Is the risk accompanying this extra duration something you’d want to take on automatically? It’s a question worth asking, especially given that the yield of the index has fallen almost in half – from nearly 5% in 2007 to just 2.7% in December of 2017. At no time has a BBAG indexer taken on so much duration risk for such a low yield.
Breaking down the BBAG
Given these realities, we believe investors must be mindful of certain considerations that come with investing passively in each of the main index components.
U.S. Treasuries: Seek relative value along the yield curve
When investors seek to replicate the Treasuries portion of theBBAG index, they are stuck buying at the points on the yield curve where the U.S. Treasury decides to issue. If the Treasury extends its liabilities by issuing more 30-year bonds, index investors must buy more 30-year bonds, and thereby extend their duration. At PIMCO, we think investors should take an informed view on overall duration, as well as on the relative value along the yield curve. Expressing such a curve view may be especially important today, given that several factors are influencing the curve – most notably, the Federal Reserve’s shift from easing to tightening (i.e., by hiking the fed funds rate and normalizing its inflated balance sheet). Moreover, the risk-adjusted reward (such as yield or total carry per unit of duration) along the curve often varies substantially, allowing active managers like PIMCO to seek to add value through thoughtful yield curve positioning.
An indexer is generally also forced each month to pay a premium for the most-liquid new Treasury issues that enter the benchmark. In comparison, PIMCO’s active strategy has the flexibility to seek alpha by taking a view on the relative attractiveness of on-the-run versus off-the-run Treasury securities and trading accordingly.
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Agency MBS: Exploit the inefficiencies
The Fed purchased massive amounts of mortgage securities during its quantitative easing program and currently holds close to $1.8 trillion of agency MBS. The inclusion of these securities in the index (despite the fact that they are locked up in desk drawers at the Fed) creates a technical distortion that may put indexers at a disadvantage. To reduce their tracking error, passive managers are stuck chasing after these less-liquid bonds and may overpay for certain MBS coupons or vintages with artificially high valuations.
Another area of inefficiency in MBS markets relates to the explicit U.S. Treasury guarantee on Ginnie Mae securities versus the implicit one for Fannie Mae and Freddie Mac-issued MBS. The value assigned by the market to this explicit guarantee has fluctuated widely, which presents a valuable potential alpha source for active managers. While indexers are forced to buy regardless of valuation, an active manager like PIMCO can seek alpha simply by rotating between Ginnie Mae and conventional MBS.
Corporates: Who is doing the credit homework? BBBe aware of your BBBs!
We believe the first flaw in tying corporate credit exposure to an index is that it essentially delegates 100% of the credit underwriting function to the rating agencies. Ifthey say a security is ‘BBB-’ and thus index-eligible, you buy it! And if they later downgrade it below investment grade and it falls out of the index, you sell it! We believe such “buy high, sell low” behavior is likely to be a money-losing proposition over the long run. At PIMCO, we try to do the opposite. We have a team of more than 60 credit analysts globally, and it’s common for the internal ratings assigned by the PIMCO credit team to diverge from those of the rating agencies. This helps us both to play defense by avoiding ‘BBB’ issuers that we believe are on the path to junk and to play offense by buying ‘B’ or ‘BB’ rated bonds whose improving fundamentals signal a migration toward investment grade.
A second consideration when tracking a market capitalization- weighted credit index, such as the IG component of the BBAG, is that by definition you are buying more debt from the most indebted issuers. Imagine if you ran a local bank, and your loan underwriting consisted solely of asking “How much debt do you have already?” and then giving whoever had the most debt the largest loan. In our humble opinion, that is not the way to lend money! Instead, we seek to identify, underwrite and lend to the borrowers that provide higher risk-adjusted returns and better diversification.
Third, and perhaps most important, is the changing composition of the corporate issuers in the index. IG corporates made up 21% of the index pre-crisis, compared with 26% today. As Figure 2 shows, ‘BBB’ rated issuers now represent almost half of this segment, up from 35% in 2007. And for those ‘BBB’ issuers, net leverage has since risen to nearly 3x from under 2x 10 years ago. Most notably, the percentage of corporates that are highly leveraged (by more than 4x) has roughly tripled in the past seven years, from about 6.6% in third-quarter 2010 to nearly 20% in second-quarter 2017 (according to Morgan Stanley Research and Citigroup Index LLC data as of 30 June 2017).
So more debt is outstanding and the companies are more highly leveraged. But are investors at least holding them accountable by demanding higher credit spreads? No! In fact, spreads per unit of leverage have never been lower, at roughly 40 basis points at the end of 2017 (according to data from Morgan Stanley Research, Citigroup Index LLC, Bloomberg Finance LP and S&P Capital IQ, based on the Citigroup U.S. Broad Investment-Grade Bond Index).
At PIMCO, we believe investor complacency coupled with aggressive corporate financial engineering (i.e., increasing leverage through debt issuance paired with shareholder-friendly activity) has made generic IG corporate debt potentially less attractive. Note that we are not advocating an overall underweight to BBBs, but we are advocating being more selective (and active) in this environment, rather than just passively buying the generic corporate index. In addition to select corporates, we also favor credit securities that in our view compensate investors sufficiently for the credit risk they’re taking – namely select securitized products, such as non-agency MBS and CLOs (collateralized loan obligations), as well as the debt of financial issuers (which, unlike corporates, are significantly less leveraged now than in years past).
BOND’s active advantage
PIMCO’s approach to managing BOND boils down to one fundamental aim: to use active management and proprietary research to strive to deliver better risk-adjusted returns (both income returns and total return) than a passively run portfolio. We seek to do this by tapping sources of potential yield from both securities and asset classes that are not in the generic index (see Figure 3); seeking to exploit inefficiencies related to liquidity, complexity and structure-related risk; thoughtful yield curve positioning; and expressing views on duration and credit risk. Through this active approach, we seek to avoid some of the common pitfalls of passive core bond ETFs and improve the risk-adjusted performance potential for investors. PIMCO has institutionalized this investment process, which has been time-tested through numerous market cycles. BOND provides access to this investment process in the ETF vehicle, which investors are increasingly adopting to construct their portfolios.
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