A piece of analysis from BMO published at the start of this month suggested the recent dovish turn taken by the US Federal Reserve and the continued easing on the part of the ECB meant there was a chance of “uncertainties to filter into corporate earnings”.
This will naturally impact both equity and bond prices and, said Terry Wood, head of ETF portfolio management for the EMEA region at BMO, “the ability of investment grade bonds to provide a decent yield”.
Given this backdrop, he suggested investors might think it worthwhile to re-assess their expectations of their bond holdings. “Although a cautionary stance should be forefront in such unpredictable times, in an environment where recessionary concerns are muted by looser monetary policy, high-yield bonds could continue to offer more attractive returns compared to their lower-risk investment grade counterparts,” Wood added.
Wood went on to say is that high-yield bonds are in effect a “risk-on substitute”, providing investors with equity-like returns but with lower volatility.
Antoine Lesne, head of ETF research and strategy for the EMEA region at State Street, suggested the most recent statistics support this view. Pointing to the Bloomberg Barclays Global High Yield Index, which is up 9.95% year-to-date , Lesne said this is driven both by the supportive macro environment and the investor appetite for yield.
“However, the scale of this performance is not a new phenomenon and is one of the features that attracts investors to the asset class,” he added.
If the performance of the global high-yield market is looked at over the past 25 years, returns have exceeded either plus or minus 10% in 13 of those years. Over the same period, MSCI World Index returns have been plus or minus 10% in 18 of the 25 while Global Treasuries have provided plus or minus 10% returns only in seven of those years, part assisted by its longer duration compared to high yield.
While not exactly a halfway house, the returns profile of high-yield does sit somewhere between equities and lower-yielding fixed-income such as government bonds. “High yield also provides access to issuers that do not necessarily overlap with equity issuers or more conservative fixed income assets such as governments and investment grade corporate issuers,” said Hui Sien Koay, iShares fixed income strategist for the EMEA region at BlackRock.
Peter Sleep, senior portfolio manager at 7IM, puts some numbers on this. “We estimate the long-term returns of high yield at around 5%, somewhere between investment grade corporate bonds at around 3% and equities at around 7%-8%.”
In terms of volatility, Sleep suggest high yield is at around 9% a year, higher than investment grade bonds at 6%, but lower than equities which tend towards the 15% to 25% range depending upon the market.
“We often see that high-yield bonds sell off at the same time as equity markets, and this is supported by the maths when we see that high yield has a reasonably high correlation with equity markets whereas the correlation of investment grade corporate bonds is very weak,” he added.
Correlation is one issue and another is liquidity. This is where ETFs play an important part in the ecosystem. Paul Syms, head of ETF fixed income product for the EMEA region at Invesco, said we have yet to see any major signs of stress in the high-yield market as yet, so liquidity has not been an issue. Yet there have been strong inflows into high yield ETFs so far this year “so this is a situation that should be monitored carefully”.
Lesne points out that, according to State Street’s data, there has been $7bn of inflows into European-domiciled high yield ETFs to date this year as part of an overall trend towards the further adoption of ETFs for gaining fixed-income exposure.
“The benefit that they provide particularly in terms of liquidity and flexibility around trade execution is attractive,” he added. “The US high-yield market is a good example of how ETFs compliment the broader high-yield market’s liquidity profile.”
Syms added that fixed-income ETFs are also fast becoming “more granular”.
“For example, within the high-yield universe, investors can now target issuers that have recently been downgraded from investment grade to high yield via fallen angels’ strategies or securities whose yield is driven by subordination in the capital structure such as AT1 contingent convertible bonds,” he added.
Liquidity in high yield for ETFs has been raised as a concern in times of market stress. Yet, as Lene points out, structurally the amounts in high-yield ETFs, both in the primary and secondary markets, are dwarfed by the high-yield cash market.
“This suggests that even in times of market stress, there is sufficient secondary market ETF liquidity for investors to trade without market participants accessing the primary market and subsequently the broader cash market,” he added. “It also highlights that, if investors tried to redeem at the same time, the primary ETF market could be used as a liquidity source especially given the scale of trading volume in the US high-yield cash market.”
Sien from BlackRock added that ETFs in fixed income perform a stabilising role, something which has been on display “time and again”.
“For example, in December 2018, an unusually wild month for investors, on-exchange trading in US high-yield corporate bond ETFs surged to a monthly record of $72bn, while trading in individual high yield bonds fell to $154bn, the lowest in four years,” she added. “The episode, like many others before it, underscored how ETFs play an important role in providing additional liquidity and maintaining healthy capital markets.”
Indeed, the importance of ETFs in actually providing liquidity dates back to the crash in 2008. “Efficient bond ETFs traded continuously on exchange throughout and after the crisis, providing large investors with a much-needed alternative,” Sien added. “Institutional adoption drove higher trading volumes, which in turn provided the foundation for today’s liquid bond ETF market.”
In Europe, meanwhile, the introduction of MiFID II has also brought with it enhanced visibility of the depth of ETF bond trading. “This in turn is driving further adoption of bond ETFs by providing fixed income investors the much needed transparency in trading bond markets,” says Sien.
So, given the current macro backdrop and the already significant role of ETFs in the fixed income world, what can we expect in terms of future fixed-income ETF expansion?
Syms at Invesco suggests further granularity. “The first wave of fixed income ETFs was largely focused around offering low cost access to broad fixed income benchmarks such as government bonds, investment grade or high-yield credit,” he said. “Over time, this has developed into offering products with narrower benchmarks such as maturity bands or single country exposure within fixed income asset classes.”
Mirroring the innovation and myriad fund launches in smart beta and ESG, Lesne agrees that greater fixed-income ETF maturity will bring more innovation. “We expect the adoption of ETFs as a vehicle for gaining exposure to both vanilla and niche fixed-income markets to continue.”
The macro environment will also play a role as low interest rates cause further changes in investor behaviour as concerns grow over the apparent limited scope for active management to add alpha, said Syms. “As investors seek higher yielding alternatives to core markets, the ETF market is likely to continue to launch products to satisfy this demand,” he said.
Sien added that innovations currently in the pipeline – or already being deployed such as currency-hedged bond ETFs which can help investors dampen unintended volatility that comes with owning international bonds – will provide institutional investors with the ability to calibrate portfolios by seeing to balance credit and duration risk, or select bonds according to financial traits such as quality and value.
And ESG will play a role, she added. “Demand for sustainable bond ETFs will grow as more people seek to match their personal values with their investments. More bond ETFs will incorporate environmental, social and governance (ESG) inputs into their methodologies, or target green bonds used to fund sustainable projects, such as solar panels and clean transportation.”
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