ETF Edge: Managing long-term risk amid a new Fed chair nominee, jobs data and market volatility

Key Concepts

• Fixed Income Resilience: Despite economic uncertainty, fixed income has shown strong performance, particularly emerging markets.
• Dollarization/De-dollarization: Discussion around potential shifts away from US dollar-denominated assets.
• US Market Concentration: Concerns about concentration risk within US indices and the benefits of diversification.
• Option Income ETFs vs. Dividend ETFs: A shift in investor preference towards option income strategies for yield generation.
• Private Credit: Increasing interest in private credit as a yield-enhancing strategy, alongside discussion of its risks and diversification benefits.
• Income Orientation: The broader trend of investors seeking income-generating assets in a changing rate environment.
• Volatility & Macro Catalysts: Anticipation of increased market volatility due to the upcoming election and a new Fed chair.

Market Dynamics & Fixed Income Outlook

The discussion began with an assessment of the current market landscape, characterized by a resilient economy, normalizing interest rate curves (long-end rates higher than short-end rates), and high market responsiveness to news, particularly surrounding the new Federal Reserve chair nominee. Despite these factors, fundamentals remain strong, with companies exhibiting robust balance sheets. Year-to-date, fixed income has surprisingly outperformed other asset classes, with emerging markets leading the way in performance both this year and last.

Joanna Gyos emphasized that while the US remains the strongest and largest fixed income market, offering stability and accessibility, opportunities outside the US are increasingly important. She acknowledged a potential dynamic where dollar strength could pressure non-US assets, but believes investors are primarily driven by the attractive returns seen in emerging markets. She stated, “The US has the strongest fixed income market…it’s the biggest opportunity set for the world to continue to invest in.”

Diversification & Global Flows

Todd Son highlighted a concentration problem within US indices, noting that a significant portion of wealth tracks a small number of US corporate names. This is driving a diversification trend, with investors moving capital into emerging markets, not necessarily selling US assets, but rebalancing portfolios. He observed that investors are becoming “smarter,” combining US exposure with emerging market opportunities and thematic investments. He noted a flow pattern supporting this idea, stating, “The flow has definitely backed up this idea of looking abroad, looking at other alternative ways to keep portfolio returns going.”

The Shift Towards Income Strategies

A key theme was the evolving landscape of income strategies. Todd Son pointed out a significant shift in flows, with option income ETFs (selling covered calls to generate income) now outpacing flows to traditional dividend ETFs. This is attributed to the return of yield in fixed income, making dividend strategies less compelling. He also highlighted the massive amount of capital sitting in money market funds (approximately $8 trillion) and anticipated a deployment of these funds into fixed income products as interest rates potentially decline. “There’s a really interesting dynamic that’s happening over the last three years. Flows to option income ETFs…have outnumbered flows compared to dividend ETFs.”

Joanna Gyos reinforced the return of income in fixed income after a prolonged period of low rates following the Global Financial Crisis. She advocated for a focus on credit, specifically investment-grade credit with a move out on the rate spectrum to triple-B rated bonds, offering a yield advantage with comparable default risk. She also recommended an intermediate duration strategy, anticipating rate declines and subsequent price appreciation in bond portfolios. “Intermediate credit is where we start with…intermediate we think is a great place to be.”

Private Credit & Risk Assessment

Private credit emerged as a significant topic, with Joanna Gyos advocating for its inclusion in portfolios as a way to reach for yield while managing risk. She emphasized the increasing number of private companies and the need to access this broader opportunity set. She highlighted the diversification benefits of products like Bond Blocks’ PCMM, which offers exposure to over 7,000 loans across 27 managers, mitigating the risk associated with single-manager private credit funds. “If you’re really looking to get the full opportunity set reach for those yields with the risk…characterist I described um I think that it's important to start um engaging with private credit and not be so um um trepidacious about what you're seeing in the headlines.”

Todd Son cautioned about potential stress points, specifically in private capital stocks and less liquid vehicles, noting recent markdowns in some private credit funds. He suggested monitoring metal names and premium/discount levels in derivatives as potential indicators of broader market stress. He stated, “If any of this private credit in the illiquid space starts to leak into other areas of the financial system…that would be my…glaring sign of risk.”

Macroeconomic Outlook & Volatility

Both panelists acknowledged the potential for increased market volatility due to the upcoming midterm elections and the appointment of a new Fed chair. Todd Son anticipated more volatility in the equity landscape and suggested considering low-volatility strategies. He also advised investors to consider moving out on the duration curve in fixed income to capture yield.

Joanna Gyos emphasized the importance of diversification and risk management, cautioning against excessive concentration in equity or extending duration too aggressively. She believes the biggest risk isn’t necessarily a specific credit event, but rather investors’ tendency to chase returns and neglect proper risk allocation. “I think we want people to be paying attention to the risk in their portfolio and adding as much income as possible.”

Potential Derailers & Key Takeaways

The primary potential derailer identified by Todd Son was a credit event in the private credit space that could spill over into the broader financial system. Joanna Gyos highlighted the risk of investors becoming overly complacent and neglecting diversification, particularly by overextending duration or chasing equity returns without adequate risk mitigation.

Key takeaways from the discussion:

• Fixed income is back: Income is returning to fixed income, presenting attractive opportunities for investors.
• Diversification is crucial: Diversifying beyond US assets and exploring emerging markets is essential.
• Private credit offers yield: Private credit can enhance yield, but requires careful consideration of risk and diversification.
• Volatility is expected: Prepare for increased market volatility due to upcoming political and economic events.
• Risk management is paramount: Prioritize risk management and avoid chasing returns without proper allocation.

Technical Terms

• Yield Curve: A graphical representation of the yields of bonds with different maturities. A steepening yield curve indicates expectations of economic growth.
• CLLOs (Collateralized Loan Obligations): Structured credit products backed by a pool of loans.
• Duration: A measure of a bond's sensitivity to changes in interest rates.
• Triple-B Rated Bonds: Bonds with a credit rating of BBB, considered investment grade but closer to non-investment grade.
• Covered Calls: An options strategy where investors sell call options on stocks they already own to generate income.
• Money Market Funds: Funds that invest in short-term, low-risk debt securities.
• PCMM: Bond Blocks’ Private Credit Multi-Manager ETF.