The fixed income exchange-traded fund (ETF) universe has developed rapidly over the past few years, enabling investors to access more esoteric and specific parts of the bond market.
As ETF issuers broaden the range of strategies on offer, investors have started dramatically increasing their exposure to fixed income ETFs. Highlighting this, fixed income ETFs have seen €95.4bn inflows since the start of 2019, taking total assets under management (AUM) to €271bn, as at the end of March, according to data from Morningstar.
However, the potential for even further development is huge. The International Capital Market Association (ICMA) has estimated the global bond market is roughly $128.3trn, as of August last year, versus approximately $68.7trn for the equity market. This highlights the potential for ETF issuers to home in on very specific parts of the market in order to empower professional investors in their portfolio construction.
As Andrew Limberis, investment manager at Omba Advisory & Investments, said: “The key benefits of fixed income ETFs are liquidity, diversification and access.
“Liquidity is a key benefit to investors that do not have the resources to research and trade at such competitive spreads. This is very much enabled by the scale and sophistication of the ETF ecosystem as well as the useful dynamic of secondary market trading of the ETF itself.
“Meanwhile, the ability to quickly reduce idiosyncratic risk that one may have from owning a few select names is a major benefit and at the drop of a hat, investors can easily access many types of bonds, from China to the US to local currency emerging markets, to CoCo bonds and inflation-linkers.”
As a result, this article will look at how investors can actively manage their credit, inflation and duration risk with ETFs while providing a deep dive into how each bucket has developed in recent years and what more issuers can do to enable efficient portfolio management.
The most advanced of the three buckets in terms of product development, fixed income ETFs – especially in the government bond space and in particular the US Treasuries market – enable investors to pinpoint specific targets that can be useful when looking to increase or decrease the duration of the overall portfolio.
For example, if an investor finds they are significantly overweight their benchmark from a duration perspective due to the bets their active managers have taken, ETFs are a useful way of tweaking the portfolio to ensure they are not overexposed to rising interest rates.
While there are not as many bonds in the gilts space, the depth of the US Treasuries market has enabled ETF issuers to launch very specific strategies over the past few years, which in turn, has led to more accurate portfolio management.
Highlighting this, Europe’s largest ETF issuer BlackRock offers US Treasury ETFs with 0-1 year maturity, 1-3 years, 3-7 years, 7-10 years and 20+ years with each strategy charging under 10 basis points. Other ETF issuers have followed suit and the options for European investors has increased significantly.
According to Jordan Sriharan, head of MPS and passives at Canaccord Genuity Wealth Management, the government bond space, in particular, has been an area where ETFs have been dominant due to the inability for active managers to outperform the index.
“With credit, it is a large universe so active managers can generate alpha, however, there is no price discovery in the government bond space,” Sriharan continued. “This is why we generally use ETFs for our government bond exposure.”
Credit is the area of the fixed income market with the most potential for ETF issuers to significantly improve their offering to investors, especially in Europe. The reason why it has the most potential is simply due to the sheer size of the corporate bond market.
ETF issuers have broadly split the market into investment grade and high yield, the largest being the €10bn iShares Core € Corp Bond UCITS ETF (IEAC) and the €5.7bn iShares € High Yield Corp Bond UCITS ETF (IHYG), respectively.
However, issuers are yet to home into more specific parts of the market such as solely ‘BB+’ bonds, for example, or high yield bonds that are only rated ‘C’. While the specific exposure has occurred with duration, investors are unable to have the same targeted exposure in the corporate bond market with ETFs.
As Sriharan noted: “Investors might take a view that the BB space is the most attractive, however, they currently cannot find an ETF that is focused on this. As an asset allocator, this is where I am predicting and hoping the market will go. One can only assume the demand simply has not come yet for these specific ETFs.”
What is driving the increasing demand for fixed income ETFs?
Another reason why this is potentially very attractive, as Sriharan pointed out, is active managers are simply not going to launch funds that are so targeted. In a space where active managers have traditionally been able to outperform due to the sheer size and idiosyncrasies of the market, this would be a strong compliment for investors.
How to defend against a potential spike in inflation is fast becoming the most important asset allocation decision over the past five years. For a while, issuers have offered exposure to inflation-linked bond ETFs, however, the market has seen some recent innovation that is taking the space to the next level.
Gaining inflation protection through gilt ETFs has typically been a challenge due to the lack of short duration gilt bonds available. This means investors are forced to own a long duration inflation protection gilt bond version instead, but this does not provide investors with a strong hedge against inflation as the underlying bonds are long duration and therefore, typically underperform during periods of rising inflation.
As a result, Sriharan said the majority of investors focus on the US Treasury Inflation Protected Securities (TIPS) market which is more liquid and has short duration bonds.
The ETF market subsequently developed to start offering exposure to inflation expectations through breakevens such as the Lyxor US$ 10Y Inflation Expectations UCITS ETF (INFU). The problem with these strategies, Sriharan highlighted, is they are sensitive to risk sentiment so have very high correlation to the equity portion of portfolios.
In response to this issue, Tabula Investment Management launched the world’s first ETF, the Tabula US Enhanced Inflation UCITS ETF (TINF), that combines TIPS and US inflation expectations through breakevens in October 2020. This is achieved by tracking Bloomberg Barclays US Govt Inflation-linked index and going long the Bloomberg Barclays US Government Inflation-Linked 7-10 Year index and short US real yields through the Bloomberg Barclays US Treasury 7-10 Year index.
This next generation strategy is an example of innovation within the ETF space that provides investors with the tools needed to express specific views within a diversified portfolio and highlights the potential for further development across the entire fixed income ETF market.
“It is definitely possible and for many investors, the existing range of ETFs would likely be an appropriate and effective way to obtain exposure to fixed income,” Limberis added. “If one thinks about what is missing or perhaps where one has less flexibility when using ETFs, there are a few areas where some fixed income investors may want more choice such as currency hedging.”
This article first appeared in Fixed Income Unlocked: ETFs take centre stage, an ETF Stream report