Having raised $39.5bn in net new assets, demand for fixed income ETFs has been very strong this year. This is not particularly surprising following the rise in yields over the past 18 months as central banks have raised interest rates to combat high levels of inflation, which has led to investors reassessing their allocation to fixed income.
There are many reasons for investors to look at ETFs as the vehicle of choice to gain access to fixed income markets. In addition to the general benefits of investing via an ETF, such as their transparency, low-cost access, liquidity and intraday trading, fixed income ETFs provide investors with the ability to target specific exposures.
The number of EMEA-domiciled fixed income ETFs has almost doubled over the past decade and, with almost 500 products available, they provide a broad range of exposures to meet investors’ needs.
The granularity of offering allows investors to target the exact exposure that meets their requirements and macroeconomic outlook. For example, some providers’ US Treasury ranges will include several ETFs targeting specific maturity bands, in addition to those providing exposure to the full curve.
This means investors can use one or more of these ETFs to achieve the interest rate risk or yield curve positioning that matches their needs, which could be particularly valuable in the current environment as views on the outlook for interest rates differ.
Alternatively, fixed income ETFs can provide investors with the opportunity to add allocations to specific parts of the market such as hybrid bonds – which sit between debt and equity – based on their outlook.
However, these choices aren’t without their own risks as, rather than relying on an active manager implementing their views, end investors need to ensure the ETFs in which they have invested continue to reflect their views throughout the economic cycle.
There are also limitations due to their indexed nature, which means they simply aim to track an index rather than take an active view on interest rates or the creditworthiness of a specific company.
That said, for investors who may have a contrarian view or at least take a more proactive stance in their portfolios, the precision of an indexed approach and the low-cost tradability of the ETF structure can be an advantage versus investing with a manager who may not share the same views as market conditions evolve.
The types of ETF to consider in the current environment will mainly be determined by the economic outlook. If investors expect more rate hikes than is being priced in by the market, then investing in ETFs with relatively low interest rate risk would be favoured.
For example, following recent data showing that UK inflation remains stubbornly high, the Bank of England is likely to be more hawkish and hike rates further during the second half of the year.
Therefore, an investor may prefer the defensive nature of a short-dated gilt ETF (which only holds bonds with less than five years to maturity) rather than taking on the interest rate risk of the full gilt curve.
Alternatively, if investors are concerned that previous policy tightening will lead to an economic downturn, then higher quality fixed income (such as government bond and investment grade credit) is likely to be favoured over riskier, lower rated bonds.
ETF flows can also provide an indication of investor thinking. In 2022, one of the big themes was a preference for high quality US fixed income, largely due to concerns about the impact of the Russia-Ukraine conflict on the European economy. So far this year there has been a reversal with high quality European fixed income favoured by investors.
Avoiding unwelcome surprises
The universe of available fixed income ETFs can be broken down into core exposures and targeted, or innovative, solutions. Core ranges tend to focus on traditional fixed income exposures such as government bonds, investment grade credit and high yield.
For the larger asset classes of government bonds and investment grade, ETFs usually allows investors to select their allocation by currency with ETFs focused on the likes of the dollar-, euro- or pound-denominated bonds, with further granularity on offer in government bonds through a choice of maturities.
In credit markets, ETFs often include environmental, social and governance (ESG) criteria, which employ a combination of exclusions and tilts to improve the overall ESG score of the index. More targeted exposures allow investors to gain access to niche areas of the bond markets.
For example, a ‘fallen angels’ ETF provides access to bonds that were investment grade but have been downgraded to high yield, which tends to depress prices around the time of the downgrade and provide more attractive entry points.
When selecting an ETF based on the index it aims to track, it’s important that there are no surprises in the performance of that ETF. One of the key advantages of the ETF structure is its transparency with full holdings available daily.
Depending on the complexity of the index, providers will either fully replicate the benchmark or use sampling techniques to hold a proportion of securities in the index to closely match its characteristics and performance. Knowing what’s under the bonnet is key to choosing the ETF which provides the specific fixed income exposure most suited to the investor and their unique objectives.
Paul Syms is head of EMEA ETF fixed income product management at Invesco. The views expressed above should not be taken as investment advice.