Fixed income ETFs are once again a crucial part of any multi-asset investor’s portfolio following a decade in the doldrums.
According to data from Morningstar, fixed income ETFs in Europe saw record inflows in H1 as investors looked to address the underweight positioning in their portfolios.
Flows into bond UCITS ETFs hit €31bn in the first six months of the year, above the previous record of €30.6bn in 2019, with total assets under management (AUM) reaching €348bn.
In particular, euro corporate bond ETFs saw the most demand with €4.7bn inflows in Q2 while investors poured a combined €6.2bn into US and euro government bond ETFs.
“The increase in interest rates has been a game changer,” Jose Garcia Zarate, associate director for passive strategies at Morningstar, said.
“Before the start of the tightening cycle, there was no yield of significance in fixed income markets other than in high-yield bonds, which many investors were reluctant to go into on concerns of loading up their portfolios with excessive credit risk. Now there is attractive yield to be found in safer areas of the bond market.”
Investors are increasingly eyeing the longer end of the yield curve amid predictions that inflation is set to return to pre-pandemic levels.
Earlier this week, the US Consumer Price Index (CPI) fell to 3% in June, its lowest level in two years and the twelfth straight month of declines.
As a result, investors are expecting the Federal Reserve to significantly slow the pace of interest rate hikes throughout the remainder of 2023 and beyond.
“Although central banks are still on tightening mode, investors are already betting on a peak to rates and are shifting the focus from the short to the mid-to-long area of the yield curve to pre-empt a change of cycle toward a period of stability in interest rates and ultimately lower ones in the longer run,” Garcia-Zarate explained.
However, it is important to note that we are not out of the woods yet. The risk of inflation remaining structurally higher-for-longer remains real for investors' portfolios, however, many are not positioned for this.
US dollar-denominated inflation-linked bond ETFs, for example, saw €460m outflows in Q2 while short-duration bond ETFs across the board also saw redemptions.
“We see significant investment opportunities in the new regime,” Ursula Marchioni, head of EMEA markets and portfolio solutions at BlackRock, said. “They are about finding granular opportunities within asset classes, and not relying on the macro environment.
“For example, in 2020, we went from maximum overweight government bonds to maximum underweight as yields plunged from the central bank response to the pandemic. We have stayed underweight since given the risks we have seen from inflation.”
Overall, staying defensively positioned is crucial given the rally in junk stocks in the first half of the year, with short-duration and inflation-linked bond ETFs still offering attractive yields with lower risks attached.