A Smart Way to Build Out a Bond ETF Portfolio | ETF Trends

Passive index-based fixed-income investors face various risks today, but they can look to factor-based bond ETF strategies that could enhance yields and limit downside risks.

On the recent webcast, Building Income-Focused Client Portfolios with ETFs, Briton Ryan, Managing Director, Head of Capital Markets, Nuveen, underscored the growth of index-based bond ETFs, which saw assets under management more than double in the past four years, reflecting the rising demand for passive indexing among fixed-income investors.

Ryan also outlined the current interest rate environment where long-term rates fell moderately on the heels of the Fed’s decision to lower rates and global central banks are in the midst of a reversal of tightening policies put in place during 2017 and 2018. Meanwhile, concerns over weak global growth and drooping inflation have pushed around $15 trillion in bonds to trade with negative yields. In the U.S., rates remain above global peers which may be contributing to a flatter yield curve.

Despite the low-yield environment, many investors still rely on fixed-income investments, but traditional benchmarks may expose people to increased risks.

Jordan Farris, Managing Director, Head of ETF Product Development, Nuveen, argued that baby boomers are entering their retirement years and their generation will be different from those whom came before them. For example, many are living longer – men who will turn 65 in 2030 can expect to live six years longer than those who turned 65 in 1970, according to the Urban Institute analysis of Social Security Administration data. They are healthier – the proportion of adults age 80 and older reporting fair or poor health fell from 43% in 1998 to 34% in 2012. In addition, they are saddled with more debt – the share of adults age 65 and older with debt increased from 30% in 1998 to 44% in 2012 and many older adults continue to make mortgage payments in retirement.

While an aging demographic may look to fixed-income assets to fulfill their everyday needs, Ryan pointed out that investors also need to face a changing make-up of the traditional benchmarks. For instance, the Bloomberg Barclays U.S. Aggregate Index, or Agg, has seen its share of U.S. Treasury exposure increase to 40% by 2018, compared to 25% in 2005. Since the credit crisis, yields on U.S. investment grade bond portfolios have dropped by around 50% while duration has steadily increased due to increased Treasury issuance.

“Investors face increasing risk in meeting investment objectives,” Ryan said. “Traditional fixed income strategies are falling short of income needs and equity strategies may involve too much risk.”

Consequently, Farris argued that there may be a better way for investors to access opportunities in the fixed-income space without exposing themselves to potential risks from market cap-weighted bond indices. At Nuveen, they employ a methodology to rebuild traditional indices by assigning each constituent to a subgroups based upon asset class, sector, credit quality and maturity; assigning underweights or overweights to each subgroup with the goal of enhancing yield; and rebalancing periodically to adapt to changing market conditions.

For example, when comparing the NuShares Enhanced Yield U.S. Aggregate Bond ETF (NYSEArca: NUAG) to the Broad U.S. Investment-Grade Fixed-Income Market, NUAG underweights Treasuries and overweights corporates and securitized debt to enhance yield opportunities. Similarly, the NuShares Enhanced Yield 1-5 Year U.S. Aggregate Bond ETF (NYSEArac: NUSA) also underweights Treasuries and overweights corporates when compared to the 1-5 Year Broad U.S. Investment-Grade Fixed-Income Market. The smart beta indexing methodology utilizes a rules-based process to include higher weights to categories with higher yields while maintaining risk and credit quality at levels similar to the Base Index.

Additionally, fixed-income investors can also match their portfolios with changing societal views. Farris pointed out that we are witnessing exponential growth in environmental, social and governance (ESG) regulations with as many new regulations proposed in 2018 as passed in the prior six years. Meanwhile, over 80% of investors say that they view advisors who discuss responsible investing as “more forward-thinking.”

To help investors better understand ESG investments, the environmental factor covers criteria like climate change, natural resource usage, waste management and deforestation. The social factor covers employee relations, diversity, supply chain management, health and safety. Lastly, the governance principles relates to board quality, executive compensation, public policy and business ethics.

“ESG factors provide an additional lens to assess company performance, can be used to enhance long-term value, and can be used to manage downside risk,” Farris said.

As a way to help investors better access the ESG investment theme, Nuveen’s ESG ETFs utilize an investment methodology that follows a four fundamental element ESG strategy, including: 1) ESG rating or captures an issuer’s performance on key ESG risks relative to peers; 2) controversy score or an issuer’s exposure and response to event-driven controversies; 3) controversial business involvement or issuer’s activity in industries that may cause significant social harm like tobacco; and 4) low carbon criteria or the carbon intensity of an issuer based on involvement in certain industries.

Fixed-income investors can also look to ESG friendly strategies like the Nuveen ESG High Yield Corporate Bond ETF (NUHY) and Nuveen ESG U.S. Aggregate Bond ETF (NYSEArca: NUBD).

Financial advisors who are interested in learning more about fixed-income strategies can watch the webcast here on demand.