The Bid – “No Time To Yield” TRANSCRIPT
Episode Description:
Bond yields are higher today than they were 20 years ago. With inflation indicators falling around the globe, the time of elevated cash rates may be drawn to a close.
Investors are moving back into bonds in record numbers, with 2023 global bond ETF inflows totaling $333 billion. Yet, as global central banks appear at or near the end of a tightening cycle designed to quell the most significant surge in inflation in decades, investors could be moving even more quickly back into fixed income.
Steve Laipply, Global co-head of iShares’ fixed income ETFs joins Oscar to help us understand what has been driving investors towards, or in some cases back, to the fixed income market and what investors should be looking for as central banks appear set to loosen their grip on interest rates.
Sources:
ETF Flows Data: BlackRock Global Business Intelligence, as of December 31, 2023. Flows for fixed income ETFs globally totaled $265 billion in 2022, compared with $333 billion in 2023. Previous annual record was in 2021 with $282 billion.
Mutual Fund Flows Data: Simfund for US MFs, Broadridge for Non-US Mutual Funds, both as of December 31, 2023. Closed end funds excluded throughout. Fixed Income Mutual Funds saw $711 billion in outflows in 2022, and $151 billion in inflows in 2023.
Inflation Data: The World Bank as of Feb. 29, 2024. U.S. annual CPI for 2022 was 8.0%, compared with previous high of 13.5% in 1980. European Union CPI for 2022 was 8.8%, compared with previous high of 12.9% in 1980;.
Yield to Worst Data: Bloomberg, as at March, 25 2024. 3 Month US Treasury Bills at 5.38%; 10 Year US Treasury Yield at 4.25%; US High Yield (based on Markit iBoxx US Liquid High Yield Index) as at Jan. 2, 2023 was 8.7%.. and yield to worst as at Dec. 29, 2023 was 7.4%.
Correlation Data: Bloomberg, as at March, 25 2024. Assessed 5 Year and 20 Year Correlation between 10 Year US Treasury Yield and S&P 500. 20 Year Correlation is 0.15%, and 5 Year Correlation is -0.03%. Based on monthly data points.
Return Data: BlackRock, Bloomberg, as at March, 25 2024. High Yield references the Markit iBoxx US Liquid High Yield Index from Jan.1, 2023 to Dec. 31, 2023. Total Return = 12.89%;
Written Disclosures in Episode Description:
This content is for informational purposes only and is not an offer or a solicitation. Reliance upon information in this material is at the sole discretion of the listener.
In the UK and Non-European Economic Area countries, this is authorized and regulated by the Financial Conduct Authority. In the European Economic Area, this is authorized and regulated by the Netherlands Authority for the Financial Markets.
For full disclosures go to Blackrock.com/corporate/compliance/bid-disclosures
TRANSCRIPT:
<<THEME MUSIC>>
Oscar Pulido: Welcome to The Bid. Where we break down what's happening in the markets and explore the forces changing the economy and finance. I'm your host, Oscar Pulido.
Bond yields are higher today than they were 20 years ago. With inflation indicators falling around the globe, the time of elevated cash rates may be drawn to a close. So what are investors doing? They're choosing bonds in record numbers with 2023 global bond ETF inflows of $333 billion.
My guest today says investors could be moving even more quickly back into fixed income. Why? The signs of market change may be coming into focus. Global central banks appear at or near the end of a tightening cycle designed to quell the most significant surge in inflation in decades, a cycle that made cash so attractive.
Today I'm pleased to welcome Steve Laipply, Global co-head of iShares’ fixed income ETFs for BlackRock. Steve will help us understand what has been driving investors towards, or in some cases back to the fixed income market and what investors should be looking for as central banks appear set to loosen their grip on interest rates.
Steve, thank you so much for joining us on The Bid.
Steve Laipply: Thanks for having me, Oscar.
Oscar Pulido: So, Steve, we're here to talk about fixed income or bonds. We often use both terms to refer to that asset class, and perhaps we can just start with a really basic question, which is, how do investors tend to use this asset class in a portfolio?
Steve Laipply: Yeah, Oscar, let's start with what a bond is supposed to do. So, a bond is basically a company borrowing from someone. So that can be you and it can be an insurance company, it can be a pension fund or what have you. But generally, the way it looks is the company issues this piece of debt. It has a stated rate that it'll pay and it has a maturity date. When that maturity date happens, you're supposed to get your money back. And so bonds, generally, trade in the market so investors can buy them outright from the issuer when they're issued, or they can just go into the market and buy them after they start trading.
Equities are more intuitive, we hope they go up, they pay us a little bit of a dividend along the way, that's great. Bonds, if all goes well, you're going to get this payment that they told you were going to get, and then you're going to get your money back, but you're not going to get anything beyond that. And so a good outcome is you getting that payment and you getting your money back.
There are different ways that people evaluate that risk. People may have heard of the credit rating system where AAA is really good and BB is not so good and there's everything in between. Investors will look at that and look at what yield the bond is going to pay them and make a decision on whether they think they're taking the appropriate risk for what they're getting paid. Getting to your question on the portfolio, bonds do two things.
The first thing that bonds do when you use the term fixed income, Oscar, income, so in a portfolio, if you think about equities, equity dividend yields are fairly low. They're around one-ish to two-ish percent. Bond yields actually, as we know before the Fed hiking cycle, were probably not too far from that but now we're in a very interesting world where bond yields are back to where they were about 20 years ago.
So you can now get a decent amount of income, in the treasury market in the 10 year note, you can get around a four and a quarter, at the very short end you can get 5.5%. And so, we're in a different world. In the high yield market, you can get much more than that. So now the income part is back.
The second thing bonds can do in a portfolio is provide diversification. That tends to be more applicable to higher quality bonds like treasuries. If you look way, way back across time, treasuries as an example, tend to move in the opposite direction as stocks. And what investors would do with an equity, heavy portfolios, is hold some amount of high-quality bonds against those so if the equities go down, they get some protection from the high-quality bonds. It's a combination of this income and diversification that investors are looking for in their portfolios.
Oscar Pulido: Right, so they provide diversification to the stock market, and you mentioned treasuries in particular, which are sort of the risk off asset class that investors will tend to gravitate towards. And then you also mentioned income, it seems like the income that fixed income generates these days is like a capital I income compared to recent years. And you talked about the fact that the yield on bonds is back to 20 year highs. So how did we get back to these 20-year highs?
Steve Laipply: Yeah, so if we, take a little bit of a journey down memory lane, let's say before 2008, we had yields that didn't look terribly different than they are now. 2008 happened, all central banks all over the world reacted, including the Fed, they cut rates to zero. We had a full decade plus of rates that were very near zero.
That's where we were. We were scraping bottom for quite a while, and that was on purpose. The Fed was really trying to keep the economy going post-crisis. And there were all these programs, quantitative easing, et cetera, et cetera, that were going on that kept yields really low. Well, coming out of the pandemic, all of a sudden inflation for the first time in many, many, many decades, and I think, a lot of, quite a lot of people probably had never experienced inflation, and all of a sudden, everyone's, googling that word and what it means and what it looked like in the past and how bad it could get, and, sure enough, it comes roaring back.
And of course, the central banks react again, going in the opposite direction, they start hiking rates really, really aggressively. And in the US, they went from zero to 5.5% in a couple years. That, some people would say shocked the system, other people who were rooting for higher yields would say they renormalized the bond markets back to where they used to be. But nonetheless, here we are.
Oscar Pulido: So, your perspective on whether interest rates or yields on bonds are high really depends on how far you go back. Compared to a few years ago, they're, they're really high. But as, as you said, if you go back 20 years ago, pre the financial crisis of 2008, they are really just kind of back to where they were in that maybe more normalized period. So, as the Fed has raised rates and done so to combat inflation, a topic that we've spent a lot of time on with some of our colleagues at the BlackRock Investment Institute. So, what has this meant for investors? Does this mean they're more constructive on putting money into bonds or do you see them sitting in cash a bit more?
Steve Laipply: It was interesting, at the beginning of the cycle which really took hold in 2022, we were all sort of bracing for significant outflows, whether that was individual bonds or mutual funds or ETFs or what have you.
It turned out to be a little more mixed than that. Yes, you saw outflows in mutual funds, but astonishingly you saw quite a lot of inflows into bond ETFs as an example. And then of course, you saw, saw a lot of inflows into, very short-dated instruments like treasury bills.
That reflects a couple things. Yes, there was a little bit of sticker shock, people looked at their statements, for example, maybe in a mutual fund they'd held for a long time and, and perhaps decided to allocate out of that and into cash. But there was also this dynamic where investors got excited about yields that they literally haven't seen, like we said, in, 20 years, give or take.
I think that explained some of this allocation that we've seen the last two years into bond funds because investors are now looking at that and saying, you know, I'm not going to be able to call the top in yields, but how about this, I haven't seen these yields in a very, very long time, and maybe it's time to start getting back in.
Oscar Pulido: Can you say a little bit more about the allocation to cash instruments?
Steve Laipply: So, by design, when you, increase interest rates this much, you know, when we go from zero to five and a half, by design, you're going to invert the yield curve. that is designed to tighten financial conditions. And that's just a fancy way of saying you want people to be defensive. You want the premium for companies taking risk to go higher for investors taking risk to go higher.
Investors responded exactly the way that was intended, which is they moved into those very, very short-dated instruments or just outright cash. Why did they do that? Well, because it turns out you're getting paid more sitting there, than you are in say, 10-year notes, right? And so that was the point. But now they have to start thinking a little bit about, are things changing, are they done? Aren't they done? When's the first cut going to come? Will it come this year?
One way or another, we're probably coming to the end of this particular Fed cycle. Investors really need to start thinking about what role is cash playing in their portfolio? And it does play a role, you should always have some cash on hand, of course, because you may need that instant liquidity to, for an emergency or, or something unexpected that happens. But having all of your money sitting in cash is probably not ideal.
And we know, the reasons for that, which is that yield that you're seeing in cash today, can very well be gone tomorrow. It can change very, very quickly. This is the conversation that's very much happening right now everywhere, which is, when do I do this? When do I start moving out of cash? I do think it is appropriate now to start having that conversation and start thinking about it because markets have a funny way of moving before they send a very strong, all-clear signal.
So they're not going to tell you when it's over and when it's time to move, you're going to have to figure that out and as it turns out, those longer yields move much more quickly than the Fed. And so they'll move before the Fed even cuts. And that's something everybody needs to be aware of.
Oscar Pulido: So there's a bit of anticipatory behavior that investors have to think about. And you touched on this concept of the yield in a cash instrument might be a certain figure right now, it can change quickly, and I think that means that there's reinvestment risk for an investor - what they were getting in their cash instrument can change. It could go up, it could go down, but it certainly doesn't necessarily have to stay stable for an extended period of time.
What does it mean for investors though, as they're allocating to the bond market and some of the areas that you mentioned when the backdrop is also one of higher inflation. So how should investors be thinking about, on the one hand, their yield is higher, but inflation is also higher. So how do you grapple those two things together?
Steve Laipply: And that's, the trick, isn't it? So you have to look at what you're getting paid, after inflation. And so this is the whole discussion. And so when people are looking at, short-term yields versus long-term yields and where inflation currently is and where they think it's going to go, a simple thing to do is just take the current inflation rates, subtract that from the yield that you're looking at, and decide if that's going to work for you. A situation you don't want to be in, and we were in the situation for some period of time, before covid was what's called negative real yields. And real just means that arithmetic we just did, where you take the yield, you're looking at and subtract inflation, and if it's a negative number that's tough, right? But, we were kind of that way in many, many countries across the globe for a long time. And we're not, now we're at positive real yields. That's, something that people haven't seen for a while, and I think that's why they're taking comfort in this idea that even subtracting inflation, you're getting a positive return.
Oscar Pulido: The term “negative real yield” translates into a stealth way to reduce your purchasing powers is what it sounds like, it also sounds like we're now in a better environment where even though inflation is higher, yields are compensating you for that and some, so investors are back to at least growing their purchasing power, even if it is a very small amount.
You touched on central banks. Will they cut, will they not? This is like a bit of an Olympic sport. I think now watching central banks and what they're going to do with policy, maybe just go back to why that is important. Why do people spend so much time thinking about the next policy decision, from the Fed and other central banks for that matter.
Steve Laipply: It's interesting when we look at how responsive the bond markets have been to these pronouncements, whether they're official statements or whether it's just a particular fed speaker, in the news cycle, markets have reacted very, very strongly the last couple years. I think it's because we just were in a period for quite a long, stretch there where, everybody was waiting to see what the outcome of this would be, are they going to land the plane?
Are they going to be able to, you know, bring this thing in for the much talked about soft landing, or are we going to suddenly find ourselves, moving far too quickly into a slowdown and will they have to react to that? So the sport has been all about, did they do the right thing? Did it work? And I think that's why Oscar, you're seeing so much attention paid because people want to know what the score of the game is, but they actually want to see what the final score is going to be. Not sure that they're going to get that satisfaction because again, I don't think the market is, is very good at just giving you these all-clear signals or, oh, the clock ran out and the final score is X. The economy is dynamic, so you might not actually get that, signal you're looking for, but that's why everybody's trying to figure out did they pull it off or not, and what will the next phase be?
Oscar Pulido: Steve, you've been working in the fixed income market, the bond market for years. And presumably you feel like you've seen this movie before where investors are waiting for clues from central banks, and as you said, trying to predict what the final score is going to be. And I think, what you're saying is that investors, should be thinking a little bit further ahead and not be overly focused on decision to decision if I'm not mistaken.
And so Steve, what's the bottom line for investors? I mean, you touched on a few of these things and, you referred earlier to moving out to, three or four years of maturities, meaning moving out of cash and moving a little further out the yield curve. But are there areas of the bond market that you're focused in on and maybe some key takeaways for investors?
Steve Laipply: This is going to sound obvious, but I think investors have to have certain views in order to make these decisions.
So let's take case one. Case one would be if an investor does believe that, you know, like we talked about before, that they pulled it off, that we're going to get this soft landing, we're not going to go into recession. They'll be able to start cutting rates very gradually, inflation will behave and continue to grind down to 2%, et cetera. You could do a lot of things then, you can have the confidence to invest in something like high yield. If you believe that the economy is, on firm footing and is going to stay that way, and high yield's offering very attractive yields. What's interesting, Oscar, last year everybody was scared of high yield because of all the talk about a recession, but it returned 13% last year. So, you know, even though it was yielding, I want to say 8, 9%, it returned something like 13%. So, you know, that was one of those contrarian things where people stayed away from it, but it generated a very good return. So if you do think the economy is going to, sort of glide into the soft landing, then you could take more risk in something like high yield or emerging markets or what have you.
If you're more defensive than that, then you want to stick to high quality. You want to be in high quality investment grade. And we talked about treasuries. You want to move a little bit further out the curve to get that diversification, get a little more duration in your portfolio to help balance out that equity risk.
If you think, I'm not quite sure, we might or might not, enter into a slowdown and I want to be a little more balanced here. Let's go with one more, which is, if you are very worried that, maybe all of this right now feels great, but we will wake up, in six months or a year and realize we're, we're in a recession. Well, you probably want to be even more overweight to that very high-quality exposure further out the curve, let's just say longer maturity or longer duration treasuries as, as an offset or diversification for the equity part of your portfolio. If you think a recession could be a real risk, and also that is the benefit of locking in yields where they are today because in that scenario, they probably will fall.
Oscar Pulido: Right. So you painted three very different scenarios, but the commonality was, uh, there's something to do. There are opportunities in the bond markets. And so we will stay tuned to see what the final score of this game is, although it feels like following markets the game just always, continues.
Steve Laipply: There’s always over time.
Oscar Pulido: There's always overtime! Steve, we appreciate your insights and thank you for joining us on The Bid.
Steve Laipply: Thanks for having me, Oscar.
<<THEME MUSIC>>
Oscar Pulido: Thanks for listening to this episode of The Bid. You enjoyed this episode. Check out my conversation with Becky Milchem, “Are you leaving cash on the table?” where we explore three things investors should consider when it comes to cash in uncertain markets. And subscribe to The Bid wherever you get your podcasts.
<<SPOKEN DISCLOSURES>>
This content is for informational purposes only and is not an offer or a solicitation. Reliance upon information in this material is at the sole discretion of the listener.
In the UK and Non-European Economic Area countries, this is authorized and regulated by the Financial Conduct Authority. In the European Economic Area, this is authorized and regulated by the Netherlands Authority for the Financial Markets.For full disclosures go to Blackrock.com/corporate/compliance/bid-disclosures
