At The Money: Karen Veraa, Head of iShares US Fixed Income Strategy, BlackRock (September 11, 2024)
Full transcript below.
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About this week’s guest:
Karen Veraa is a Fixed Income Product Strategist within BlackRock’s Global Fixed Income Group focusing on iShares fixed-income ETFs. She supports iShares clients, generates content on fixed-income markets and ETFs, develops new fixed-income iShares ETF strategies, and partners with the iShares team on product delivery.
For more info, see:
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TRANSCRIPT: Karen Verra Bond Duration
[MUSICAL INTRO: Time is on my side, yes it is. Time is on my side, yes it is.]
How should investors manage bond duration in an era of rising, and likely soon falling, interest rates? The challenge: Long-duration bonds lose value when rates go up. Shorter duration bonds can also lose value, but far less.
What happens when the reverse occurs when rates fall? Well, the value of long-duration bonds go up Shorter duration go up, but less.
As it turns out, there are many ways investors can take advantage of changing interest rates.
I’m Barry Ritholtz, and on today’s edition of At the Money, we are going to discuss how to manage your. fixed income duration when the Federal Reserve becomes active when it comes to interest rates.
To help us unpack all of this and what it means for your portfolio, let’s bring in Karen Veraa.
She is head of iShares U. S. Fixed Income Strategy for investing giant BlackRock.
Barry Ritholtz: Let’s just start with the basics. What is duration? Why does it matter? And why does it seem so confusing to so many bond investors?
Karen Veraa: Duration is simply the interest rate risk of a bond. Or you can think about it, it’s the amount that the price is going to change in response to a change in interest rates.
So, the nice thing is today, almost any bond or bond fund will typically have that duration number published. So, if the duration, for example, is five, if interest rates go up, By 1 percent that bond will drop in value by 5%. So it’s a pretty easy relationship to think about.
I think where it gets tricky is that that’s just an average for the bond or for the bond portfolio. But there’s also durations or the interest rate risk at different points on the yield curve. So like two year – we call those key rate duration – you can think of how much am I exposed to the 2-year point, the 5-year point, 10-year point. 20 and 30.
And then we also have something called credit spread duration. How much does the bonds price change in response to changes in credit spread or the additional yield over treasuries? So when investors think through, interest rate risk and how much risk they want to take duration is a helpful measure for at least quantifying the loss that they could have from changes in rates.
Barry Ritholtz: So let’s look at some real-life examples. The Fed began raising rates in March 2022. About 18 months later, they pretty much finished, and we were over 500 basis points higher than we began. How did that impact bonds, both short and long-duration?
Karen Veraa: We actually had, in 2022, one of the worst years in terms of bond performance in decades. The Agg or the aggregate index – which is the broad measure of the taxable bond market – was down about 13%. And that has an intermediate duration or duration of between five and six years.
However, long bonds had double-digit losses. I think 20-plus-year treasuries were down over 20%. And I think that was really hurtful for a lot of investors who had moved into bonds just coming off of the zero interest rate policy that the Fed adopted after COVID.
Barry Ritholtz: And if memory serves me, I think 2022 was the first year since 1981 where both stocks and bonds were down double digits. Very unusual, you know, twice a century sort of thing.
Karen Veraa: That’s right. And it really comes back to, you know, why were interest rates going up? Why did stocks underperform it? And it goes back to the inflationary environment. Post-COVID inflation came back into the system and the Fed needed to tighten interest rates in order to stop inflation and, and get the economy back on track.
And so, we had investors reacting to that and that’s why we saw a year where both asset classes were down.
Barry Ritholtz: Prior to the initiation of that rate hiking cycle in 2022, it felt like, at least for most of my adult life, going back to Paul Volcker as chairman of the Fed in the early 80s, interest rates pretty much did nothing but go down. It felt like, hey, for 40 years, we had nothing but lower rates.
Is that an exaggeration or is that pretty much what took place?
Karen Veraa: No, no barrier spot on. We did, we have seen interest rates fall and I think it’s for a few different reasons. I think the central bank got better at managing inflation – so if inflation is lower than the absolute level of rates are lower; we saw globalization where things became cheaper, more efficient.
And we also have an aging population. And in various studies, we’ve seen that as economies age, interest rates tend to be lower because consumption behavior changes. So we had all of those tailwinds kind of pulling interest rates down over the years.
Barry Ritholtz: So that 40 years, as far as you know, is that the longest bond bull market in history or at least in us history? I don’t know what happened in Japan a thousand years ago, but…
Karen Veraa: I think in modern, we could say modern history, I think that that is a fair statement.
Barry Ritholtz: And probably unlikely to ever be matched again in our lifetime, or perhaps our kids and grandkids.
So, let’s talk about what started a couple of years ago. The yield curve inverted. How does that impact bond investors? If you’re getting paid the same for long duration as you are for short duration, why would you want to hold long duration paper?
Karen Veraa: Yeah, we’ve seen these inverted yield curves. They typically happen before recessions, and they typically happen when the market expects short-term rates to come down following a period of rates being sent higher.
So in Q3 2024 we’re at the point where the yield curve is still inverted. And the response has been pretty amazing by investors. They’ve all moved into ultra-short duration bonds, money market funds, bank deposits are at all-time highs.
In fact, even in August with a lot of the market volatility, we just observed, we saw very strong flows coming into money market funds. So people are, are literally sitting in cash. And we have some data on the average financial advisors portfolio is about 7% in cash or ultra short-term bonds, which is, which is down from, um, over 10-15%. So now they’re sitting at 7%.
So we’re still seeing a lot of even professional investors are keeping their, keeping things in cash in response to this inverted yield curve.
Barry Ritholtz: Let’s take a closer look at that: For, for a long time investors or cash holders were getting practically nothing for a decade or so, but after the Fed brought rates up to five and a quarter, you could get 5 percent and change in a fairly risk-free money market. What sort of competitions does that create for longer-duration bonds and, and are money markets truly considered liquid cash? How do you categorize them?
Karen Veraa: Let’s take the money market fund question first. We do see money market funds are considered cash equivalents. You can typically get your money back within a day, uh, just depending on the cutoff cycle with your, um, with the provider. We see a lot of people sitting in, in those cash and ultra short-term investments because they are liquid and they are yielding a lot.
However, we’re seeing more people wanting to add some duration. So if I can get 5% today, that’s great. But if the fed starts cutting. In September, December really moves that overnight rate back down into that 3% range, which is what we think it will do over the long term. Those 5% yields are going to disappear on you.
So we are seeing investors building bond ladders, adding intermediate duration, because when that yield curve does start to reshape more normally, where you get the most bang for your buck is in the belly of the curve. Three to seven-year maturity. So not only can you lock in 4 or 5% yields there, but then you can get some price appreciation when interest rates begin to come down.
So that’s really what we’re seeing investors doing right now is moving out the curve a bit in response to the falling rate environment that’s coming.
Barry Ritholtz: I’m glad you brought that up. We’re recording this right after the Labor Day holiday weekend in 2024. Everybody has pretty much agreed. Jerome Powell has come out and said it.
Hey, we’re going to begin cutting rates. The long wait is over. And you mentioned 15 trillion, went down to 7 trillion in money markets. Is the assumption that a lot of this is flowing into intermediate or longer-dated bonds in anticipation of the Fed cutting? What is going on
with all that cash moving around.
Karen Veraa: We absolutely have seen a lot of people are still staying put. So we don’t see people moving until they need to, until they actually see the rates drop on some of their money fund money market funds. But we are seeing some money coming into bond ETFs, both index funds and active funds.
We’re seeing more people building out bond ladders. So, uh, through term maturity ETFs, such as our I bonds. So we are seeing some of the money move. We’re actually looking up north to Canada – Canada has gone through a few rate cuts now, and we’re seeing money in that market move back into bonds quicker than in the U S on a percentage basis.
So I think we’ll, we will see a lot of money move this fall and into 2025. I think when people actually notice that the rates are coming down and some of these cash-like products.
Barry Ritholtz: Pardon my naivete for asking such an obvious question. If you wait for rates to fall to move into longer-duration bonds, haven’t you missed it? Don’t you want to extend your duration before the rate cuts begin?
In fact, we saw rates move down appreciably in August following the most recent – the CPI data point was very benign; we’ve seen the, the restatement of labor data, which says, hey, the labor market while it’s still healthy, it’s much less overheated than we previously thought.
It seems like the bond market is way ahead of both the stock market and the Fed. How do you look at this?
Karen Veraa: Markets are great about getting ahead of the next cycle, and we have seen that. We’ve seen interest rates coming down across the curve even before the Fed has moved. We think, though, it’s not too late you’re still going to get.
There’s some uncertainty about how quick the Fed is going to cut, how quickly their yield curve is going to reshape. So we’re even using some of these days when rates go back up a bit, those are, those are good entry points or better entry points to come back to bonds. So we don’t think it’s too late. And I think that the investors could rethink their strategy today to kind of get ahead of the next wave of cuts.
Barry Ritholtz: So that’s the perfect segue into investors who are interested in fixed income and yield. What should these folks be doing right here at the end of the summer in 2024 and heading into the fourth quarter?
Karen Veraa: I would say, think about your cash position. What are you using that cash for? If it needs to be liquid for expenses and emergency fund, keep it there. But if it’s part of your investment portfolio and you’re just seeking the highest amount of income, you should think through what are the return expectations over the next 3, 5, 10 years, and really use the opportunity to get that asset allocation back on track, that stock and bond mix, and move out to some more intermediate duration, um, because we think that’s really where you’re going to see the biggest change in interest rates, and you could get the most, uh, both price appreciation as well as still some pretty compelling income.
Barry Ritholtz: And our final question, how should investors be thinking about the risk of longer duration fixed income paper?
Karen Veraa: Longer duration fixed income paper does have almost equity-like volatility. It does have kind of double-digit volatility.
We do see it as a very efficient hedge against equity markets. So if equity markets fall, we tend to see that flight to quality, and investors go towards those long duration, especially treasuries.
We have a treasury ETF, TLT — it’s 20 plus years. It actually sold the highest amount of inflows of any ETF vehicle, in the month of August because people were trying to hedge some of that equity market volatility. So if you have a portfolio that’s very heavy in equities, 80, 90 plus percent, you could add a little bit of long-duration bonds and that would help smooth out the portfolio returns over time.
So that’s really the role that we think of with longer-duration bonds.
Barry Ritholtz: So to wrap up: Investors who have been enjoying 5% yields in money market and managing very short term duration bond portfolios should recognize, hey, rate cuts are coming. Jerome Powell said they were coming. This cycle is likely to last more than just a cut or two.
The bond market is already starting to move yields down and if you wait too long, you’re going to miss the opportunity to lock in long-duration, higher-yielding bonds as the cycle begins.
I’m Barry Ritholtz and this is Bloomberg’s At The Money.
[MUSIC: Time is on my side, yes it is. Time is on my side, yes it is.]
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