Inside ETFs: Can higher yields work for your portfolio?

The bond market is offering decade-high yields, but should your portfolio take the bait? Fed Chair Kevin Walsh wants bond investors focused on the economy, not every word coming out of his mouth. So far, they're doing the opposite. Since taking the job, the three biggest daily moves in the US treasury yield curve have followed Walsh's appearances. After Jackson Hole, he sent global bond yields back towards their highest levels in nearly two decades. So when he takes the microphone, should bond investors take cover, or take a position? Well, let's ask Steve Lightly, Global Co-Head of iShares Fixed Income ETFs at BlackRock. So Steve Walsh kicked off his tenure saying markets were learning to play the ball, not the referee, casting the Fed as a neutral rather than a market mover. But markets clearly aren't treating it that way. Is that ever going to change? The idea that they're a dispassionate observer, that's not true. Their job is to influence monetary policy through the Fed funds rate and other tools. So they are, to varying degrees, an active player in the market. I think what he was trying to say is the market perhaps has become overly dependent on messaging and forward guidance, and he wanted to walk that back some. Well, traders are pricing in an almost 70% chance of an interest rate hike this month. Do you expect the Fed to deliver? And what would that mean for the outlook for treasury yields going forward? From our perspective, we don't necessarily think it's a lock. The market is pricing in a very high probability, but we do have some numbers that will come in ahead of that. And so we'll just have to wait and see. I do think we'll get more clarity as the data starts coming in. And does that change your outlook for yields going forward if the Fed does hike or stands pat? This is about whether they surprise us or not. So as we said, the curve is pricing in two and a half hikes. A number of participants think the markets move pretty far and pretty fast. Real yields on 10-year are up 70-odd basis points since the start of the Iran conflict. Interestingly, inflation expectations haven't moved all that much. And so some folks think that we have gotten pretty far ahead, and we need to see how this data actually materializes. The bond sell-off poses a fresh challenge for Treasury Secretary Scott Besant, with many investors aren't counting on a sustained reversal. So as we revisit those pain points, could the Treasury be forced to step in again? Liquidity management operations are a normal part of what Treasury does. I think he's been clear in his statements that he's not seeking to change the equilibrium price. He's more interested in preventing any dislocations due to the absence of liquidity. And so I think what he's also potentially doing, when you do have thinner markets and less liquidity, technical trades can run pretty far. And so perhaps he's sending a bit of a signal that he's prepared to bolster liquidity to keep things from getting dislocated beyond fundamentals. Meanwhile, the correlation between stocks and bonds has turned positive, meaning that bonds have started contributing to equity losses instead of offsetting them. So has this made investors rethink bonds as a risk hedge? What's the pitch for bond ETFs now? Well, it's interesting. So we've had these rising yields now for a while. And we've actually, if you go back and look at a longer time series, we've kind of round-tripped from, on the 10-year as an example, from sort of the high 3% range all the way up to 5%, all the way back down, and now we're trending towards 5% again. Through all of it, investors have very persistently been allocating back to bonds. Bond ETFs in particular have just seen year after year of record flows. This year already, globally, you've seen over half a trillion come in. And so we continue to send you records. And I think what you're seeing is investors looking past this volatility. Sure, nobody wants to see their losses on their portfolio, but I do think investors are looking past some of the volatility and dislocations. And they're really focused on the income component. We are very focused here on income as a really important part of portfolio construction now. And so you can do that in a number of different ways. This year, our flows have been all across different exposures and durations. So we've seen roughly 50 billion of our flows into treasuries. And interestingly, this month, that's been kind of split between the very shortest and the very longest exposures between USGOV and TLT. So I think a lot of investors may be surprised by that, but it shows you that they are looking at the high level of real yields as a tremendous opportunity. We've also seen flows across multi-sector investment grade. It's generally been a quality trade, but the bottom line is the money does keep coming into bonds. So finally, Steve, how do traders prepare going forward? Will the composition of ETFs change quickly as the high bond yields persist? Stock bond correlations are going to fluctuate. And in fact, we've done a very deep dive into this research-wise. And over the decades, it's waxed and waned. And it's really what investors are focused on is income. And so they're looking to put in layered sources of income. So liquidity using very short-dated treasuries for that correlation, that ballast trade using longer-duration treasuries for core income using multi-sector funds and high-quality investment grade. And then looking at defined outcomes, using things like defined maturity ETFs like IBONs to really target duration and manage against very specific liabilities or cash needs. So it's not just one approach. It's a multi-layered approach. But income's at the center of all of it. That was Steve Lapley from BlackRock. Don't forget, you can watch more videos on Reuters.com.