The September issue of Crane Data's Bond Fund Intelligence newsletter features an interview with Brett Wander, Chief Investment Officer, Fixed Income, at Charles Schwab Investment Management (CSIM). In the article, entitled, "Schwab CIO Brett Wander on Bond Funds, Chasing Yield," Wander discusses a range of issues, including the risks of chasing yield, the liquidity challenges in the bond fund space, and why rising interest rates could be a good thing for short-term bond funds. As he tells us, "There's a significant distinction between the Fed raising rates slowly versus the Fed raising rates quickly." We reprint our interview below, which originally was published on Sept. 15. (Contact us if you'd like to see an issue of our new Bond Fund Intelligence product.)
BFI: How long have you been in the world of fixed income? Wander: I've been in the fixed income world for more years than I could even count -- about three decades -- and I joined Charles Schwab Investment Management four years ago. CSIM has run both money funds and bond funds since the early 1990s, so has a lot of experience in Fixed Income. Whether we're talking about money funds, long or short term bond funds, our experience goes back a number of years.
BFI: Tell us about your bond funds. Wander: Outside of money funds, CSIM manages two categories in the bond fund area: fixed income ETFs and fixed income mutual funds. With regard to our ETFs, these are all passive strategies that are benchmarked to indexes and our goal is to meet the index on those strategies. We have four fixed income ETFs and they basically cover the U.S. investment grade portion of the fixed income universe. We have a Treasury based ETF, an Aggregate-based ETF, a short-term Treasury based ETF, and a TIPs ETF. So they are all high quality government and corporate-based strategies. In terms of fixed income mutual funds, we have taxable and tax exempt funds, including both active and passive strategies, so it covers quite a range.
BFI: Are you looking at expanding your roster of bond funds? Wander: We're always mindful of new products that we can offer that can be helpful to our clients. We're certainly aware of changing market dynamics with money fund reform, so I'm sure that at some point we'll be talking more about it. Changing regulations and changing market dynamics certainly plays into our thinking as it relates to the potential need for new products.
BFI: What kind of growth have you seen in the bond fund segment? Wander: We've seen some pretty significant growth in fixed income, and we believe it's a very important asset class for our clients. It's important to keep in mind that when equity markets are volatile, fixed income strategies can be a stabilizing counter balance. Also, as we see interest rates start to rise, fixed income could become a much more interesting place for investors.
BFI: What are the biggest challenges for bond funds? Wander: There are three significant challenges in the marketplace related to fixed income. The first is the low yield environment, and the second is the changing regulations that impact our marketplace. Connected to this is the third aspect, which relates to liquidity in the fixed income marketplace. I'll touch on each. We've been in this incredibly low yield environment for a number of years now, and we find that yield-oriented investors get very discouraged about this. We've been advising our clients that even in a low yield environment, we don't recommend making significant changes to the risk profile of their strategies. While investors can always get more yield by taking on more risk, that's something that we want to discourage investors from doing without a lot of careful thought and consideration.
Anecdotally, six or seven years ago if you had a 5% yield target, you could accomplish that with Treasuries. A couple of years ago you could achieve that with investment grade corporate bonds. Today, you need to go into the high yield space to get a 5% yield. So the punch line is -- if you just simply maintain your yield targets, you would find yourself taking on a pretty significant increase in risk which we strongly discourage. A lot of investors employ fixed income strategies as a way to offset the risks in the equity markets. But the more you stretch for yield, the more you're becoming equity-like, and that can mitigate some of the benefits associated with investing in fixed income. The second challenge, changing regulations, raises all kinds of potential concerns -- dislocations in the marketplace, liquidity, and investor confusion.... You find a lot of unintended consequences due to the regulations. The third challenge relates to liquidity, which connects back to changing regulations.
BFI: What about the liquidity concerns? Wander: The liquidity conditions in the fixed income marketplace have changed meaningfully over the last several years. When I started in this industry, you could trade a $100 million corporate bond with very little market impact. Today you'd have to chop that trade up into ten or twenty smaller trades in order to accomplish that level of liquidity. Fixed income liquidity is definitely an issue. However, not all bond funds are the same as it relates to fixed income liquidity. There's this tendency to think, well if it's fixed income, it automatically means it's illiquid or potentially problematic. But the reality is there's a huge spectrum. It's important to realize that the higher quality parts of the fixed income market, even in the liquidity crisis, are likely to maintain a greater degree of liquidity than the lower credit, more structured products in this market. In short, the higher the credit quality, the greater the liquidity. Our products, by and large, are investment grade. We are willing to forgo a little bit of yield in order to maintain better risk characteristics and better liquidity characteristics. We think that's an advantage to investors.
BFI: What kind of diversification do you have in the portfolio? Wander: We have internal guidelines in all of our Fixed Income products that often go well beyond what the prospectuses require. One of the most significant aspects to managing fixed income is attention to risk management -- that's key to our investment process. No matter how attractive, no matter how high a yield, no matter how compelling an individual sector or security is, it's always critical to be highly diversified. Consequently, we have very strict guidelines in our strategies in terms of the percentage that we would own in a given credit or a given issuer. As you move from the triple-A part of the marketplace down to single-A and into the triple-B, the lower the credit quality becomes, then the more diversification we require.... [Y]ou never want any one security or sector to dominate the investment results of your portfolio.
BFI: What are your thoughts on the regulatory environment? Wander: We are entering uncharted waters here -- these are completely unprecedented events in terms of the degree that reform and regulation can impact the marketplace. We are mindful of the fact that companies are changing their product offerings -- some in response to money fund reform -- in the midst of an extremely low interest rate environment. We could see some unusual dislocation in the front end of the yield curve, not just in the money funds space but even in the longer part of the marketplace, which typically isn't the money fund space but is the short term bond space. You could see some interesting market dynamics where the relative demand for government securities could create some interesting opportunities and relative value in the credit space.
BFI: Do you expect we'll see higher rates? What are the risks and rewards? Wander: First off, thank you for not asking me to predict when the Fed is going to raise rates (laughs). So let's talk about the prospect of rising rates -- there are a couple of key thoughts I would emphasize here. Number 1, there's a significant distinction between the Fed raising rates slowly versus the Fed raising rates quickly. It creates a completely different dynamic in the marketplace. If the Fed were to raise rates quickly, meaning faster than what the market is expecting, you could see price declines in fixed income and that could possibly lead to outflows.
But if the Fed were to raise rates slowly, which they certainly seem to be on track to do, it significantly reduces the potential volatility in the fixed income market place. The vulnerability of short term fixed income funds to significantly underperform in a gradually rising rate environment is very different than in a fast moving rate rising environment. Look at what's happening today. In short term bond funds, we've started to see yields rise slowly as the market priced in expectation for future rate hikes. But because it happened so gradually, we've seen very little in terms of negative price performance. That's an important thing to keep in mind. Furthermore, there is a huge distinction between short term and long term rates. Long term rates are primarily driven by growth and inflation expectations. It's certainly conceivable that long term rates could fall even as the Fed begins to raise short term rates. The Fed cannot control long term rates.
BFI: What is your outlook for bond funds? Wander: The strong bull market for bonds that we have seen over the past thirty years is not likely to be repeated, because we're starting from a level in which yields are lower. Back in early '80s, you had double digit yields so those outsized returns aren't likely to be repeated. However, the likelihood of rates rising significantly in the very near term is not terribly high, and I think the market expects that. We're in a very low inflationary environment and as long as inflation remains contained, it's not likely that yields are going to skyrocket. Bond fund returns are likely to be pretty close to expectations and as long as that's the case, they offer good diversification against the stock market. Here's the ultimate irony, if rates do start to rise, as long as it's gradual, that will entice more investors into the fixed income marketplace. So we could actually see an increase in demand for bond funds.
