Last year saw the greatest increase in fixed income ETF assets on record, with net inflows hitting almost USD90 billion says Antoine Lesné, (pictured) Head of SPDR ETF Strategy & Research EMEA .
In the sustained low rate environment, investors are seeking greater choice and flexibility to increase yields in their income portfolio — and increasing allocations suggest a belief fixed income ETFs offer that potential.
The fixed income landscape has changed. Since the first fixed income ETF was launched in 2002, the global market has grown to around USD500 billion. Impressive as this is, it leaves enormous room for growth considering this represents just 0.5 per cent of the USD100 trillion1 global fixed income market.
And this trend seems set to continue. The sustained low rate environment of the last several years has contributed to a global thirst for yield. In addition, the number of fixed income ETFs has increased rapidly, providing investors with a greater set of implementation opportunities.
This is largely due to the surge in popularity of ETFs in general. By the end of 2015, 37 companies had launched ETFs for the first time, taking the total number of ETF providers up to 276 globally, according to ETFGI. More than 6,100 ETFs are now available to investors globally.
In the current market environment, investors would do well to consider fixed income ETFs that offer exposure to across the government and corporate bond EUR and USD curves, helping them to build broadly diversified, global fixed income portfolios in a more cost effective and transparent manner. With cost and transparency are two of the characteristics that feature among investors’ priorities in the post-financial crisis world.
But what about active?
Traditionally, fixed income has not had a close association with the passive investment process. That has changed. One key advantage emerging from the growth of ETFs is that investors can now access even niche areas of the market without needing specialist active bond managers or access to the underlying bond market directly.
Institutional investors, with their typically large bond portfolios, have been front and centre in adopting fixed income ETFs. They have found ETFs to be an attractive way of gaining exposure to hard-to-access areas of the market such as high yield, convertible bonds, or emerging markets bonds. Furthermore, they are often able to do so at significantly lower cost and with more transparency than actively managed alternatives.2
The advantages of passive vs active in fixed income
The “active versus passive” debate has long been hot and contentious. The debate intensifies when it comes to fixed income, and there are fierce discussions over traditional actively managed market segments, such as emerging market debt and convertible bonds.
However, there is evidence a passive approach to fixed income may offer a more consistent and predictable source of performance. Even in some less efficient markets, such as high yield and emerging market debt, the ability of active approaches to consistently outperform their benchmark has come under question. In the three-year period to December 2015, a remarkable 83 per cent of the 30 largest actively managed funds underperformed their emerging market debt local currency benchmark.3
In addition, active managers often allocate fixed income portfolios to non-benchmark sectors. This can make risk management more challenging. For many fixed income investors, consistent and predictable returns are primary objectives, making the decision on which benchmark to select all the more important. Among other characteristics, the CFA Institute believes an appropriate benchmark should be unambiguous, investable, measurable and appropriately representative of the opportunities available.
The liquidity paradigm of fixed income ETFs
Since the onset of the financial crisis individual bond liquidity has declined. At the same time, institutional use of fixed income ETFs has increased exponentially. As inflows increase, so too does the liquidity of ETFs’ secondary market; according to Markit, trading turnover in fixed income ETFs has increased more than 400per cent since 2008.
As a result of this, the structure of an ETF may offer several advantages during a liquidity event. The presence of a liquid secondary market may offer price transparency and the ability to liquidate positions, without touching the ‘primary market’.
As a minimum, investors may consider fixed income ETFs to be as liquid as their underlying securities given ETF shares can be exchanged for a basket of the underlying bonds known as the primary market.
Improved transparency and cost efficiency
Investors in Fixed Income ETFs can make their trades on exchanges. This can offer a layer of liquidity that can not necessarily be found with their underlying constituents that still trade on the fragmented “over-the-counter” bond market. This aspect of secondary market liquidity is a driving force behind increased fixed income ETF use. For instance, one benefit is the on-screen liquidity of ETFs that track niche areas of the market, such as high yield, and which trade at tighter spreads than the underlying basket of constituents.
This dynamic generally leads to increased volume in the secondary market. Regulations such as MiFID II should further improve transparency. According to a report by Dillon Eustace, perhaps 70 per cent of trades across 1,519 ETFs listed in 21 European countries are not reported on-exchange. MiFID II would require public disclosure of all such over-the-counter trades, allowing for a more accurate reflection of how each vehicle is trading.
Opportunities for investors
The rise in fixed income ETF investing shows no sign of abating. Since the first fixed income ETF launched in 2002, the market has endured the 2004 Fed tightening cycle, the credit crisis, sovereign debt crisis, the fiscal cliff, the debt ceiling debate, the “taper tantrum,” the energy bear market since mid-2014, and fears of a Grexit. Along with the introduction of 280 other fixed income ETFs during this period, market events over the last 14 years have showcased the efficiency and merit of employing fixed income ETFs.
The fixed income market will continue to evolve and the pace of divergence of monetary policies of the world’s major central banks is something to monitor as we progress through 2016. The US Federal Reserve has begun tightening monetary policy while the ECB has adopted a large-scale quantitative easing programme. Other factors will also play on investor minds; fears of a possible Brexit are fermenting, while concerns about Chinese growth and currency devaluation remain a feature of market chatter.
As regional monetary policies diverge, political landscapes change and economic growth prospects fluctuate over time, the flexibility of ETFs to invest across the yield curve may prove particularly beneficial for many investors. The fixed income ETF universe has expanded to the point where an appropriate ETF is likely available to satisfy the specific needs of most investors. And if there isn’t, the rapid growth of this market to date suggests it may only be a matter of time.
1 Source: ETFGI as at 30 November 2015.
2 Source: State Street Global Advisors, Bloomberg. Based on actively managed funds and ETFs as of 31 January 2016.
3 Source: Morningstar Direct, data as of 31 December 2015. The universe is generated by selecting 30 largest live funds as of 31 December 2015 with the primary prospectus benchmark of JPM GBI-EM Global Diversified Index and available track record history of 5 years or longer.
