Wealth Builders - A StatonWalsh Podcast

Top Gun & Bonds

July 07, 2022 Kevin Flanagan Episode 15
Wealth Builders - A StatonWalsh Podcast
Top Gun & Bonds
Show Notes Transcript

Top Gun and Bonds, what could they have in common? Make sure to listen in on this weeks episode to find out as we are joined by a very special guest, Kevin Flanagan. Kevin is the Head of Fixed Income Strategy at Wisdom Tree Asset Management. One of the topics we continue to see in the headlines is the talk around rising interest rates. We also talk about inflation and the strategies investors can use in the fixed income portion of their portfolios moving forward.

 
This podcast is for informational purposes only. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon only when coordinated with individual professional advice. StatonWalsh and Founder’s Financial Securities do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation.

Ryan Staton is an Investment Advisor of, and securities offered through, Founders Financial Securities, LLCMember FINRA/SIPC and Registered Investment Advisor.

Devin Walsh  is an Investment Advisor of, and securities offered through, Founders Financial Securities, LLCMember FINRA/SIPC and Registered Investment Advisor.

Check the background of this firm on http://brokercheck.finra.org/

Speaker 1:

Hello everyone. And welcome to this week's episode of wealth builders presented by StatonWalsh. In this week's episode, we have a very special guest Kevin Flanagan, head of fixed income strategy at wisdom tree asset management. Kevin comes to us with a wealth of experience in all things fixed income. In today's episode, we discuss topics like rising interest rate environment, inflation as well as strategies investors can use in the fixed income portion of their portfolios. Moving forward, we hope you enjoy this week's episode.

Speaker 2:

This is wealth builders presented by StatonWalsh, a show designed to pull back the curtain of the financial industry and bring true transparency to the forefront of conversation. On the show, we cover topics like financial education, current events, and interview business leaders and industry experts with the ultimate goal of helping listeners discover their own path to financial independence. Welcome

Speaker 3:

Everybody to this week's episode of wealth builders. And this week we have a very special guest Kevin Flanagan, who is the head of fixed income strategy at WisdomTree asset management. Also with Brandon Liebman, who's the director at WisdomTree. So super, super excited this week. Um , Brian , I know you are as well. We're talking all things fixed income, big hot topic right now. So we're super excited to have Kevin and Brandon on the show. Um , make sure also listen to Kevin's podcast. It's a great listen , um , called basis points . So definitely go out there, listen to him, but Brandon, I'll turn it over to you. Give us the more background know we've had you on the show before. Give us a little more background on wisdom tree , who you all are and just kind of kick off the episode that way.

Speaker 4:

Absolutely. Thank you Devin . Good morning everyone. Uh , my name's Brandon Liebman, the director from wisdom tree asset management wisdom tree asset management is a asset manager specializing in exchange traded funds ETFs with over 70 billion assets under management across the globe. And as Devin mentioned today, we have Kevin Flanagan, one of our top resources, our head of fixed income strategy. One of our leading voices in the fixed income space, part of our model portfolio investment committee, he's been at WisdomTree for well over six years. And prior to that was a managing director at Morgan Stanley for 20 plus years. So a wealth of experience and as Devin, as you mentioned , uh , a lot of things going on in the fixed income landscape today. So it's great to have Kevin on the line and I'll turn it back over to the team.

Speaker 3:

Awesome. So, Ryan , um, how would you kick us off Ryan get , um , started about talking about fixed income today and hear more little about Kevin.

Speaker 1:

Yeah. So thank you everyone for being on. I think as far as fixed income is concerned, I'll just kick it off with you. Kevin, just give us a little bit of an introduction for the layperson out there. Fixed income is a term that gets thrown a lot around a lot. And most people when they think fixed income, they think bonds, but just give us a , a rundown. What exactly does fixed income mean to the average everyday investor?

Speaker 5:

Well, I think for most people when they're, they're looking at either headlines or watching TV or whether it's on the internet or, or whatever, and they're hearing stories or headlines of fixed income, it's traditionally what is known as the money in bond markets, right? So what we're talking about are debt instruments for a variety of different institutions. It could be the us government, it could be government agencies like Fannie Mae, Freddie Mac . It could be collateralized what we call debt instruments. In other words, they may be backed by a mortgage or some other type of loan agreement and also corporations where you have investment grade companies and high yield high yield, I guess in some people's parlay, maybe they'd be more familiar with the term junk. And there's also foreign debt markets as well, very similar to here in the us where you have sovereign debt, which would be like treasuries in another country as well as corporate debt as well. So it's a global market and it's not just maturity say 10 years or 30 years, it runs the gamut. And that's why I , I kind of lumped together money and bond markets. When you talk about fixed income, because we could talk about maturities as close to one week, maybe in nature all the way out to maybe 50 years in nature. So it's very broad, very encompassing and includes a whole host of different what we would call issuers who are looking to borrow money, have investors help pay for that, and then providing interest rates as a result or interest income along the life of the debt instrument. Okay ,

Speaker 1:

Great. Thank you for that. So generally speaking, I think most people believe that fixed income in some way is a little bit of a we'll call it a safe Haven or something that's more stable in an investment portfolio, but this year seems to be an exception to that, especially in the , the first six months of 2022 . So give us a little insight. Why is that? What happened and why do we see fixed income as an asset class actually following suit to some degree that the volatility of the stock market.

Speaker 5:

So Ryan, you really wanna hit me where it hurts. Don't you ?

Speaker 1:

Sorry . Um , don't have , have to ask

Speaker 5:

<laugh> you're right. I mean, all kidding aside, traditionally, right ? Fixed income in general. And I would refer to it as more investment grade fixed income, right? Like before that doesn't include, say junk or emerging markets, that type of a thing. So talking about it from that vantage point. So obviously the fed has played a big role in what we're seeing so far this year, last year we saw interest rates rise, which is kind of the ban of the treasury market existence, right? Or fixed income in general, rising rates means lower principle and vice versa. So last year, the premise for rates rising was not all across those different maturities. I mentioned before, it was more intermediate or long data maturity say seven years, 10 years, 30 years. And that was due to the runup that we saw in inflation this year, it's been across the board. And when I say across the board, not just in the maturity spectrum, but also with respect to sovereign debt credit markets, as I mentioned before, pretty much all along and that's due primarily to the fed, the prospect that the fed was gonna begin to reverse the unprecedented easing of monetary policy due to the COVID and COVID related lockdowns. So that includes raising rates. I know people have talked about it. You probably don't wanna go down that rabbit hole, but quantitative ease . I'm sure people, if they turned on CNBC, they've heard the term QE while they're reversing all of that now. And there's a lot of uncertainty as how aggressive the Fed's gonna be in that process. And it's created an environment where interest rates were so low. It's almost as if the only place they had to go was up. And that's what we're finding out this year. And unfortunately this is gonna be the landscape for at least the remainder of 2022, if not into 20, 23 as well, because the Fed's just getting started. What's interesting is that, you know, there's been so much publicity about the fed raising rates . They've only raised rates three times this year, so they still have some catching up to do. And , and in that regard, we could continue to see the bond market facing challenges in the months , if not quarters

Speaker 1:

Ahead. That's an interesting point. You bring up a few other things as far as being in a relatively low interest rate environment for an extended period of time. So with the fed raising interest rates, one of the things we see in , in our practice, especially when we talk to retirees is being conservative and still generating yield and interest and kind of earnings on our money in a safe and secure way. It's been relatively challenging with a low interest rate environment with bonds. You talk a little bit about the relationship between interest rates and inflation as well. So give us some context there, you know, as rates go up to combat inflation, like really, what does that mean in the context of like, as an investor or someone just looking at what's my money gonna be doing for me in the market? How do the two go hand in hand and , and what is the direct effect of one on the other

Speaker 5:

Originally, right? I mean, and , and this is not to be overly critical of the fed chairman. A lot of other market observers felt it its way that they were looking as the increase in inflation last year, that the T word , right? Transitory, in other words, it was a temporary development, not permanent, something that would reverse course and essentially revert back to where we were before. But we found out for a variety of different factors that that was not the case and what inflation tends to do if you have a fixed income instrument. So just for arguments, say kind of going back to bonds 1 0 1, if you're invested in a bond and it's providing you interest income, say twice a year, based on the coupon, right. Of what it may be 3%, 4% coupon. Unfortunately it was more like one to 2% a year or so ago. And since that's fixed income, right, it's not being adjusted for anything as inflation comes into the mix. That means that whatever that income you're getting, your purchasing power goes down . You're not able to buy the same, say amount or degree or magnitude of goods and services that you had prior to inflation. So that's why that's really the enemy of the bond market. And what the fed wants to do is that because it can also have other unwanted or unintended consequences on the inflation side as well. So that's the primary reason why when you're a bond investor, you don't like inflation because it's going to eat away at that fixed income you are getting from that debt instrument.

Speaker 1:

Got it. That's great. And it's interesting because it does , it does create a little bit of a , a challenge for investors that they see rising interest rates could be seen as a good thing. But then again, when you have inflation numbers that are north of 8%, a 4% interest rate doesn't seem so attractive anymore. So with some of the increases in rates, one thing, another, I guess, hot topic or jargon that gets thrown around when we turn on channels like CNBC, for example, they talk about things like inverted yield curves. Could you talk a little bit about that? What exactly does that mean? What effect does that have? It seems to always have a negative connotation with it, especially in regards to equity markets as well. But could you talk a little bit about that concept and what exactly that means for those that are

Speaker 5:

Yeah, so right. The term inverted to me, right? Top gun Maverick, it's the movie, right? Right now that's, that's in the box office. If you go back to the original, right. I mean, I remember the question they were asking, well, how could you see the Russian pilot or whatever? And he said, because we were invert, right. And what, essentially, if you can try to conceptualize that is it's kinda like upside down . So in other words, a traditional yield curve, when we say it's positive , that means the difference in interest rates say between a 30 year bond and let's call it a three month T bill will be positive that you would expect since I am lending you money, essentially for the next 30 years, I want a higher interest rate because there's risk involved over say a 30 year period. Whereas if you're invested in say a three month security, there's far less uncertainty because technically you'll be getting your money back in three months, not 30 years. So you don't ask for the same kind of let's call it interest rate protection. So what happens when the yield curve inverts it's completely the opposite, right? It's upside down just like Maverick, that what you're looking at essentially are interest rates in that three month area, two year area are actually higher than where they are in a tenure or 30 year type of maturity. And one of the key reasons behind that over the course of history has been due to fed policy that the federal reserve, when they raise interest rates, the more clear or direct impact that they have on the bond market is in those shorter dated maturities. Because what the fed is doing, they're raising the cost of overnight money. That's the federal funds rate . So when you turn on Yahoo finance, when you turn on CNBC and they say the fed raised rates three quarters of a point, that means they increase their federal funds rate by that much. And that is the cost of overnight money overnight lending. So as you move further out in maturity, you have less of a direct relationship to overnight money. So that's why you have these shorter dated maturities will adjust higher because of that, because they're tying in to what the fed is more or less directly doing, whereas something that's 10 or 30 years out, they may be saying, Hey, if the fed raises rates too much here, maybe they slow the economy. And now the debate is maybe they push us into a recession, which would mean the interest rates come down. So what happens is you have this positive shaping slope of say the yield curve we were talking about that starts to get adjusted. So just try to picture something at the bottom, something at the top, and that something at the bottom starts to move up, that something at the top starts to move down. And at some point they could become equal. At some point, they become that inverted, that negative spread relationship where interest rates in shorter data maturities are actually higher than for longer data maturities.

Speaker 1:

Excellent visual as well. I think a lot of people for those who have seen the original top gun, know what you're talking about and not like you said,

Speaker 6:

You see the new one now ,

Speaker 1:

Now , now I'm, I'm more motivated than ever. So with that rising rate environment that we're kind of living in right now, if that continues, which it seems like it will, based on what the fed has said, their policy will be through the end of the year. Do we see that as a good or a bad thing for fixed income markets?

Speaker 5:

That is a great question. So it really, it varies on what your risks parameters are, what your income needs are. What are you looking to get outta your fixed income portfolio? So if you would just say for argument's sake, we saw this in the 2018 last time the fed was raising rates. I think it occurred in early 2019, the treasury issues, floating rate notes two year floating rate notes. Okay. At one point they were, and they're reset every week with the three month TBI auction. So that's what they float off of, right. People hear about floating rate debt as a means of rate hedging to help insulate their bond portfolio. Because as I said before, if you're a fixed coupon, you're kind of left hanging out there. If you have a floating rate instrument that helps hopefully to protect some of the principle that you've invested in fixed income. So for a treasury floating rate note that is adjusted every week at one point was the highest yielding treasury security. So this goes back, Ryan , to your question about inverted yield curves versus say a 30 year bond. So think about that. Something that is adjusted every week was actually higher in yield or a rate than what we saw for a 30 year maturity. So for that period in time, investors would say, Hey, geez , why not capture that coupon, that interest income. And I only have something that is far, far less sensitive to changes in rates on principles, something known as duration. Believe me , I won't go down that rabbit hole. And then you have, or would you rather have a rate equal to, or less than that. And you're holding onto this for 30 years. So oftentimes, you know, investors would say, Hey, I'd rather have that treasury floating rate note . That makes more sense to me. But then you get to the point where let's just say for arguments sake, this isn't a call, but let's say we do go into a recession. And the fed then has to reverse course say in 20, 24 and start lowering rates, then you may wanna be further out on that yield curve. Maybe you wanna be in a 10 year or a 30 year because as interest rates fall, that price sensitivity is more going to occur in those longer dated maturities. So you could actually think of it as, as the stock market. You could actually see the price of the bonds. Remember there's that inverted? There's that term again, relationship between rates and principle, right? Rates go up, price goes down, rates, go down, prices, go up. So you may be in a position in your bond portfolio. At that point, it's like, you know, something, maybe I'd like to see the price of my bombs go up. So what we tend to do is talk about a barbell strategy where you kind of marry the two concepts together. So it's a time tested approach where think of a barbell , whatever the weightlifter is lifting, you have the barbell and on either end, you have two weights, just say for arguments sakes, one of them is a treasury floating rate. And another one say is a 10 year security on the other. And you can toggle the weights back forth that way. You're really not making a prediction on where you think rates are going. It's more of a strategic type of allocation, which I, you know, investors tend to be looking at in their model portfolios. You could always make tactical adjustments based upon current situations, which lends the flexibility of the barbell approach is something that is , is certainly investors would welcome. So that would be, I , I think when you're looking at fixed income, investing something that we talk about, something that we emphasize rather than saying, Hey, I think rates are gonna go up. I'm just gonna be in that short maturity. I think rates are coming down. I'd rather be way out on the yield curve to try to get price appreciation. We say compliment the two, marry the concepts and, and hopefully it provides less headaches when you look at your monthly statement,

Speaker 1:

Oh , that's great. And I think ultimately a different form of diversification. It's funny why you were talking through that. I was thinking in my head, it sounds like this bond market or fixed income market specifically has become in this environment more of a strategic dynamic, tactical, whatever term you kind of want to throw at that. But as we all I think understand and are aware of the average everyday investor and most of the people we're crossing path was just don't most don't have the bandwidth to do that. And most wouldn't want to. So that's an interesting strategy though. The barbell strategy, it sounds to me like you're kind of, you're taking a little piece from both sides. You're kind of standing on both sides of the fence at the same time. And that way you don't have to make a prediction. You can kind of just let it all play out. And either way, you're gonna have some form of protection in both scenarios. So that's very interesting. So outside of that strategy, I guess, where do investors go in a high inflation environment? Where do they go to find more yield or more income from their portfolios based on, on what we're , what you're seeing today with the fixed income landscape.

Speaker 5:

That is a great question because we are watching the fixed income bond market landscape changing right before our rise . I mean, we were just talking to the point a couple of minutes ago of historically low interest rates, right? It , it seems pretty much since the financial crisis and the great recession that has been the challenge for, for bond market investors. Where do I find income in the bond market? It's interesting if you go back to June of 2007 , um, can't believe that's 15 years ago now . And we were, this was before the financial crisis really began to hit in terms of the headlines and the markets a 10 year treasury note was yielding around five and a quarter just to provide some perspective. So we got down to during C I think in August of 2020, we got down to one half of 1%. So 0.50 . So almost five percentage points below where we were in, in June of 2007, just to provide some perspective. But now you're seeing that 10 year treasury note the other day, or I should say about a week ago was flirting with three and a half percent. So we're making up for lost ground. And when you look at, I was talking before about right other aspects to the fixed income or the bond market investment grade, corporate bonds, high yield corporate bonds. You're starting to see interest rate levels now that are not quite where they were in 2007, but they're certainly above where they have been. And just for instance, if you look at an investment grade index us investment grade corporate bonds as of this past Friday, which would be June 24th, the index was showing a yield of about four and three quarters percent high yield was getting close to eight and a half percent. These are numbers that are more, let's call it, quote unquote , traditional in nature. And you know, it gets back to the point, right? I , I guess me, unfortunately being a , a ranger fan and even more unfortunate for Brandon being a New York Islander fan, but you know, hockey just ending with avalanche Wayne Greski was always skated to where the puck is going. And that's why I think your question is right on the money, because it's like, okay, where is the puck going? And if rates are gonna continue to move higher here, you may find fixed income reverting back to the more traditional role it had been used in the past as passed as quote unquote , fixed income, right? That is not equity type related, like you would see in the stock market. So I think it's gonna be to me, I think it's gonna be interesting to see how that plays out, not just later this year, but what if we do avoid a recession and the fed is not inclined to have the lower rates, it will be fascinating for, for me to see how investors look at some of these yields in the market, you know, the same holds for municipal bonds as well, right? I mean, you know , there's so many different avenues out there that you could be looking at, but yield levels. In other words, rates what we're seeing now, the search may not have to be as difficult as it had been over the last say five, 10 years.

Speaker 1:

Sure. No, that's great. And I think an important point that you made there is that, that we always, I think emphasize is maintaining perspective. One thing that we see a lot is that investors, they tend to have short memories. They don't remember a time where you referenced the 10 year yield back in 2007. And a lot of people, their new barometer for where rates are, or what rate environment we're in is , is mortgages. And a lot of people have, have gotten some pretty cheap money over the past 5, 6, 7 years. And ultimately we're kind of going back to a place that as you said, is a little more normal or traditional. So we are also interested to see kind of how that plays out. I know that having a interest rate on your mortgage, for example, that's 5% seemed like a complete stretch and ridiculous. Even seven, eight months ago, a lot of people were living in the, the threes and, and high twos. So it's definitely important to maintain that perspective and understand like where we fall on the historical yield curve, if you want to , if you wanna say that. And I think that all makes perfect sense and , and sounds great. So, Devin , I know you had a question about fixed income outside the United States so much .

Speaker 3:

Yes . Yeah. So I just like for diversifying inside your bond portfolio and fixed income portfolios, you know , talking about emerging market bonds, international bonds, whether it's an ETF or just your thoughts on invest in fixed income outside of the us ,

Speaker 5:

It gets back to what I was saying before, in terms of what is the investor's parameters, what are they looking to achieve in the bond part of their portfolio and trying to look at it in a holistic approach as well, because Todd's favor, you have things other than bonds in your portfolio like stocks, maybe you have commodities, maybe you have alternative investments as well. So you have to be mindful of that. You may not want too much of a concentration in one area or the other, but I think when you're looking at let's call 'em non dollar bonds at this stage of the game, most of the developed world we're seeing or have seen a reversal, right? I mean, you don't hear negative rates as we have been a couple of years ago, right? I mean, negative rates now, even in the developed world, those G seven kind of countries has really been eliminated, been removed. I mean, we even have something like, we've talked about the fed. So the fed version in Europe, the European central bank, finally talking about raising their interest rates. I can't remember the last time we had that kind of a discussion. So even with that though, yield levels here in the us still tend to be on the higher end versus a lot of our counterparts say in France, in the UK, certainly in Germany, you know, areas such as Italy, the rates will be higher there than they are in the us . But there's a reason. I mean, there's a reason why interest rates are higher. Getting back to what I was saying before on that front, when I look at offshore non dollar bond investing. So there are normally two risks that you focus on in the bond market. You look at interest rate risk, which we've done a lot of talking about or credit risk. You know, we mentioned investment grade or high yield type of credit, right? In other words, downgrades defaults, that would be something in the credit risk bucket when you're adding, unless it's gonna be dollar based . If you're adding what we call local currency, offshore non dollar bonds to your portfolio, then you've added currency risk as well. So that's a question I think that that needs to be answered by the individual investor themselves. Are they willing to assume that other leg of the three-legged stool when they wanna go offshore some do some don't at this stage of the game, some would perhaps make an argument that I've been hearing lately that perhaps emerging market debt is offering opportunities at this stage of the game. I don't necessarily argue with that, but once again, the question is, do you want to add that to the risks because you're talking about currency and then you're also talking about credit risk because they're emerging markets, right? It's not Germany, it's not the UK, it's not France. It's not even Italy. It's in the emerging market space. And we just saw with what happened, unfortunately with Ukraine and the Russia war Russia was in a variety of different emerging market debt, packages, funds, ETFs, or something along those lines. So these are all, I think, important considerations when you're looking at the non dollar bond market.

Speaker 3:

These are all great insights. Kevin, we , we just thank you so much for taking the time to be with us today. And thanks again , Brandon . So if you give us just all the listeners , just one final thought on everything going on right now for your finish up on that bond market, the fixed income, what would it be?

Speaker 5:

I would say use that strategic approach, Ryan, that , you know, we were talking about earlier, where you have a , a core bond type of positioning, and then you compliment that accordingly. How do you want to invest in terms of your income needs? What is your time horizon? What are you looking at, which is why the barbell approach is an interesting strategy. It's something that is time tested. Some people talk about laddered portfolios, where you basically straddle different maturities as a ladder , the rungs of a ladder. Well , a barbell is basically a ladder, but without the rungs , you have the top step in the , and the lower step.

Speaker 1:

Thank you for that. And two important to mention , I know we covered a lot of different areas of fixed income and interest rate policy and all kinds of , of good stuff today. I just would redirect listeners again to Kevin's podcast basis. Points goes into a little bit more detail on some of these topics, really short, digestible episodes, really awesome content. We, again, we appreciate all of your insight here today and thank you and thanks to the team over at wisdom tree for, for participating in providing some education. So thanks again. And , uh , hopefully we'll have you guys on again here soon and we'll do some updates and, and see where we stand in this whole landscape maybe in , uh , sometime later this year.

Speaker 5:

Thanks for having us. Appreciate it

Speaker 3:

So much. Appreciate .