New ideas breath life into bond ETFs

by , 17th October 2017

Debt can be a tough nut for ETF issuers.

Monetary easing has driven bond yields to record lows. Yet the reputation of high yield (junk) debt remains stained by the 2008 financial crisis.

But how can ETF issuers square this circle? This article looks at some of the new ideas issuers are bringing to bond ETFs.

Fallen Angels

One idea for high yielding but safe bond funds are the dramatic sounding fallen angels ETFs.

Fallen angels are companies that have very recently had their debts downgraded from investment grade to junk. Which might make them sound like a bad investment idea. After all, why have ratings agencies if you’re going to do the opposite of what they recommend?

But investing in fallen angels is a great idea, many argue. Because when corporate debts get downgraded, they tend to get ditched hard and fast as funds to shred them to meet their investment mandates (shredding can also come from other ETFs, too, which track investment grade indexes).

These quick fire sell-offs can lead to overselling. And the overselling means investors can get solid yields at a premium. As my colleague David Stevenson notes, “If the fallen angel manages to survive we begin to see a curious phoenix like rehabilitation occur – investors have assumed the very worst, but in their rush to ‘judge’ they’ve ignored the corporate restructuring that has resulted in a robust return to profitability.”

Third party brands

Another idea ETF issuers toy with is bringing in third parties to give a seal of quality.

Here, one noteworthy fund is the PIMCO Euro Short-Term High Yield Corporate Bond Index Source UCITS ETF (EUHA). Investors reading the name of this ETF might be led to think “PIMCO is listing an ETF!” And that’s part of the idea.

The fund is actually provided by Invesco, via its European subsidiary Source. But the all-important index it tracks is put together by PIMCO in California.

Invesco, one would think, believes that they can leverage the PIMCO brand. This is evident in the fact that PIMCO’s name appears as the first word in the ETF – a privilege usually reserved for the ETF issuer itself. (In this regard ETFs are kind of like Hollywood billings – the most important name is thought to come first!)

The strategy could well be helpful. PIMCO is regarded by many as a top authority on bonds and fixed income and Source thought of as an ETF issuer. So why not turn credit the bond selection to PIMCO and leave the ETF issuing to the issuer?

Extreme diversification

The first, second and third rules of investing are diversify, diversify, diversify.

ETFs, it could be argued, almost always do this. Indeed, indexes have a kind of in-built diversity, do they not? This is true, of course, of bond ETFs (like the rest) which track indexes composed of many different types of bond.

But some issuers have taken bond diversification to another level. To take one example, Columbia Threadneedle recently listed its Diversified Fixed Income Allocation ETF (DIAL) in the US.

DIAL does more than almost any other bond ETF to diversify its holdings. Not only does it track debts from every corner of the globe, it also tracks every type of debt. From investment grade US corporates, to zero yield T-bills, to corporate junk bonds, to the sovereign debts of small emerging market countries.

It could be argued that there is such a thing as too much diversification. And as DIAL is very new, how it performs is yet to be seen. But this level of diversification can certainly help offset risk – and in a way that is new to bond ETFs.

Short-term maturity dates

Another idea that is becoming more popular among ETF issuers is taking high yield bonds, but reducing the risk by shortening the maturity dates.

And how do shorter maturity dates help lower risk?

Well, because a short-term maturity date makes bonds less vulnerable to interest rate rises. They mean that if interest rates do rise, there will be less debt outstanding. As Investopedia notes “if you would like to invest in a bond with minimal interest rate risk, a bond with high coupon payments and a short-term to maturity would be optimal.”

There are many products in this range, offered from all kinds of issuers. We’ve also very recently seen this taken up by ETMFs. For example, the Calvert Ultra-Short Duration Income NextShares (CRUSC) listed on NASDAQ.

Conclusion

Fixed income ETFs are predicted to be the next big thing. And in these times, characterised by peculiarly low interest rates, issuers wanting to keep yields high but risk low will have their work cut out for them.

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