Diversifying your portfolio with fixed income ETFs

Alessandro Rollo on using fixed income ETFs to diversity your portfolio

Alessandro Rollo


Nowadays, it is especially institutional investors like pension funds, insurers or banks who have allocated a portion of their investment portfolio to bonds. Retail investors are still underexposed to this asset class. They usually perceive it as difficult to understand or at least not as interesting as investing in stocks. But there are many reasons why everyone should consider investing in fixed income: not only because of bonds’ intrinsic characteristics, which can make them attractive but also in terms of overall portfolio construction. Of course, there are also risks that should be monitored closely by investors.

When building your investment portfolio, it is known that including different asset classes can provide diversification without necessarily sacrificing financial returns. Stocks and bonds have traditionally exhibited a relatively low correlation of returns, which means that when one asset class goes up in value, the other doesn’t necessarily do the same or at least in the same amount. This contained correlation can prove very useful, especially in turbulent times like the ones we are living in. It is worth noticing that only 2022, in terms of correlation between bonds and stocks, proved to be an exception: both asset classes went down considerably. This was due to a mixture of factors like the rapid rate hikes brought forward by the major central banks in the world. However, if we look at the historical averages, the argument is still valid.

One way to invest in bonds is through ETFs. These instruments, because of their contained costs, transparency and diversifying effect, prove to be ideal candidates for this task. Picking manually bonds from single issuers should be considered carefully as it means incurring in high credit, interest, sector and geographical risk just to mention a few. Instead with ETFs, you are automatically buying a pool of underlying bonds, thus reducing the risk. There are several ETF investment strategies to include bonds in your investment portfolio.

The most known and popular is definitely investing in sovereign bonds, which are emissions backed by sovereign states. For example in Europe bonds issued by states members of the Eurozone are common and widespread among investors. The same goes for the ones issued by the US. They bring along little risk as they are backed by states which are unlikely to run into financial difficulties and won’t be able to service the payments. While entailing low risk, they can provide regular income, although only of a moderate entity. Investors in fact cannot expect high yields on bonds with very high ratings. ETFs offering exposure to sovereign bonds allow to access a diversified pool of emissions. For instance, an ETF of this kind focused on the Euro area would allow investment in a portfolio of bonds issued by governments of state members. And nowadays it is possible to choose freely among ETFs of this kind offering exposure to different credit ratings, maturities, geographical focus as well as several other features: accordingly, the degree of personalization is high. However, through an ETF it is not possible to obtain a personalization as high as by buying single bonds.

However, besides the popular sovereign bonds, there are many other investment strategies within this asset class. It’s interesting to consider also emissions from corporations. Although they entail a higher risk, they can also provide a higher regular income. Just like for government bonds, also corporate ones receive a rating based on their credit risk, namely the risk that the issuer won’t be able to pay the coupons or the principal. The rating is assigned by leading agencies and ranges from AAA to CCC, where the latter is the denomination for junk bonds. Investors can choose among ETFs investing in corporate bonds with different ratings, based on their risk appetite. Also here a wide choice in terms of geographical areas, sectors, and other features is possible.

In the corporate bonds spectrum, it is worth mentioning other strategies that not all investors are aware of. First one of fallen angels. These are bonds that have been downgraded from investment grade. Because in fact of some corporate information or news that got released, rating agencies changed their outlook lowering their rating. When this happens, usually many market participants sell the bonds that are now classified as junk bonds: for example, frequently, some institutional investors are not even allowed by their mandates to invest in this kind of emissions. This can lead to a market anomaly where there is an oversold situation that a fallen angels ETF seeks to exploit. With this strategy there is also the potential to benefit from the so-called rising stars, which are bonds that after having been downgraded, get again upgraded to their previous level, bringing along a potentially interesting price appreciation. However, it is important to underline the risks of this strategy: normally these downgrades take place because the issuers’ financials have substantially deteriorated or some bad news has been released. Investors should be very careful when investing in this type of emissions as they carry with them a high risk. The majority of bonds incorporated in this strategy are in fact below investment grade, which means the risk of default is not to be overlooked.

To sum up, bonds can represent a great tool to diversify an investment portfolio without giving up on financial returns. As seen, there are many different strategies within this asset class that investors can choose, with ETFs representing a valid way to access them. Of course, bonds present also risks that need to be monitored.

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