Fixed income, the winning portfolio

O’Leary (SsgA): “Emerging market debt and high yield should have a place in a portfolio for investors with a longer term investment horizon”

In a context characterized by low interest rates, which opportunities are in the bond market? And then, what is the growing role of the ETFs in this environment? We asked it to Niall O’Leary, Head of EMEA Fixed Income Portfolio Strategy, State Street Global Advisors.

Could you give your suggestions about the best fixed income portfolio in light of the current market scenario with negative yields from treasuries?
With short term government yields so low to negative, investors are forced to consider taking more interest rate risk (by buying longer maturity bonds), more credit risk or more currency risk to achieve decent returns.
At this stage in the cycle I have a bias towards diversification as the outlook is uncertain but I would favour some long duration government bonds. I believe low interest rates will be with us for some time and that this will exert downward pressure on yield curves. Moreover, I do not believe that inflationary pressures will negatively influence bond yields in the near future. I also believe Emerging Market Debt and High Yield have a place in a portfolio for investors with a longer term investment horizon. Both asset classes have struggled in recent times but, at these higher yields, they offer value and merit inclusion if you can live with the short term volatility.

What about high yield? Are there any relevant difference between US and Europe?
There are considerable differences between the US and European High Yield markets. However, there are two sectors that standout. Using BoA Merrill Lynch data at the end of February 2016 we can see that the energy sector is far bigger in the US market, representing 10.5% of the universe versus 4.0% in Europe. The challenges that the energy sector have faced in the US have been well documented, with the collapse in the oil price having a massive impact on the young fracking sector. The energy sector has fallen dramatically in the US: it represented 14.4% of the index back at the end of June 2015.
On the other hand the banking sector is a very large part of the European High Yield market, representing 19.5% of the index versus 4.9% in the US. The size of this sector reflects so called “fallen angels” in the European market – these are former investment grade issues of banks and it includes a large element of subordinated bonds.
The influence on returns is stark: in 2015 the US High Yield index generated a negative return of -4.64% whereas the European High Yield index generated a positive return of 0.76% (again based on BoA Merrill Lynch index data). When you look at returns of different sectors we see that the energy sector in the US High Yield index generated a negative return in 2015 of -23.6%.

Could you briefly describe SPDR ETFs range in the fixed income segment?
The SPDR range of ETFs cover broad and targeted exposures across sovereign debt, investment grade and high yield corporate bonds, as well as emerging market debt. SPDR ETFs is constantly innovating in the fixed income domain. We launched the first emerging market debt local currency ETF in May 2011, and launched the first global convertible bond ETF in October 2014. All SPDR ETFs are physically replicated and benefit from State Street Global Advisors’ deep experience in fixed income beta management. We manage $320bn in fixed income beta assets, with around $40bn in ETFs (as at 31 December 2015).

Which factors you suggest to take into consideration when selecting Fixed Income ETFs?
The rapid increase in the number of exchange traded funds (ETFs) in recent years has made the task of navigating the investment landscape more challenging. So we’ve created a practical framework to help investors to select the Fixed Income ETFs that can best meet their needs, whether they are seeking risk, yield or diversification.
The first point is considering whether the ETF aligns with investment objectives, in term of risk tolerance, investment horizon and diversification of the overall portfolio. Secondarily, you’ve to consider if the index aligns with portfolio. Understanding how the ETF replicate the underlying index may have implications for the ETF’s tracking error, cost and risk.
Third, it is crucial to examine the issuer reputation in the ETF marketplace and whether it has the appropriate resources and skills in fixed income investing.
Fourth, cost profiles. An ETF’s total cost ownership often compares favourably to a mutual fund’s expense ratio. The total cost of gaining exposure includes factors such as the swing factor, the average daily trading volume, the ETF spread and broker fees.
Last but not least, liquidity is a key topic, as the trading route directly impacts the bottom line. A good ETF issuer will be able to help each professional investor assess the best route for their particular investment requirements.