Doug Blanton is the Director of Investments at Merit Financial Advisors. Doug assists financial advisors in developing investment strategies that focus on their client’s needs. We recently sat down with Doug, who will be speaking at our ETF Strategy Summit (Oct. 15 – 16 – Dallas), as he shared his thoughts on investing in bonds in a rising rate environment.
ETF Strategy Summit: Investors have become comfortable with active fixed income ETFs and many strategists argue that they are superior to bond indexing – is there still room for passively managed bond funds in wealth management portfolios?
Doug Blanton: During this phase of the credit cycle, we prefer active fixed income to passive. As rates rise, and investors shift assets out of bonds, liquidity may become a concern. You will want nimble active managers to navigate a major spread widening or credit crunch. Credit research will also be key as we reach higher interest rates. We don’t believe credit-worthiness becomes much of an issue until 2020, however the market has a way of accelerating the pain for the most vulnerable names which we would expect active managers to recognize and limit exposure. We believe passively-managed U.S. Treasury and short-term high quality debt ETFs will make it through the next credit cycle without much consequence.
ETF Strategy Summit: With lower returns projected well into the future, should advisors re-think the proportion of assets they allocate to traditional bond strategies? Does the “balanced portfolio” need a facelift?
Doug Blanton: Our team regularly challenges the traditional balanced strategy. Bonds are historically less risky, and still offer some of the best negative correlation to extreme market or economic events. However in the absence of such events, one must consider the long-term return expectation of each asset class. The mistake we see some making today is an emphasis on value-oriented stocks and other high dividend-paying income alternatives. Most of these have a very long implied duration and will likely experience continued drawdown as rates rise. So you must choose your bond alternatives wisely to avoid the excessive interest rate sensitivity.
ETF Strategy Summit: What kind of tools does Merit use to navigate the rising rate environment?
Doug Blanton: Our process utilizes a number of economic and market indicators to assess our views on inflation and interest rates. Inflation during this expansion is being born from the expense side of the ledger, meaning higher wages and raw materials have accelerated price increase. We follow the inflation dollar to determine how much impact the consumer is likely to feel. So far, companies have been able to absorb much of the increases in part due to rising revenues and stiff competition. In addition, we believe there is a lot of data between the month-ends, so we look at how markets react to certain events or stress points no matter how small. We evaluate the behavior of our portfolios during these “mini-cycles” and adjust accordingly.
ETF Strategy Summit: Are you concerned that the use of bond ETFs as hedging tools might send investors false signals about the state of fixed income markets?
Doug Blanton: The asset inflows bond ETFs have seen during the past few years does tend to lead investors to conclusions. At the end of the day, the bond market can be a very illiquid environment. Asset flows influence investor outcomes, and those flows often get the direction and the magnitude of a particular view wrong. We don’t view asset flows as a reliable data point to determine strategy.
ETF Strategy Summit: How do you feel about hedging against inflation? Are TIPS sufficient?
Doug Blanton: The implications of higher inflation on the credit markets is one of our largest concerns. We have been steadily decreasing our interest rate sensitivity since 2015 in anticipation of rising rates. We have gone from a 5+ year duration down to 1.5 years, with 50% of our bond exposure including some floating coupon rate feature to hedge against rising rates. TIPS are a good inflation hedge in a worsening economic environment. However we find the credit alternatives offer a larger total return given the positive global economic picture. Should inflation become destructive, dampening economic growth, TIPS would be our top pick for an inflation hedge. But as of today we have very little exposure to TIPS.
ETF Strategy Summit: Thanks Doug. We look forward to hearing more of your thoughts at the ETF Strategy Summit October 15 – 16 in Dallas.