FIXED INCOME: A maturing market

BlocksDevelopment of fixed income ETFs has been slower than for equities. David Stevenson looks at how the sector is trying to catch up, with a greater focus on duration and maturities looming. The exponential growth of equity ETFs has not been matched by fixed income, yet there are a signs of great customer demand. Investors ploughed $44 billion (€40 billion) into bond ETFs globally from the beginning of the year until July, according to figures from consultancy ETFGI. According to James Waterworth, vice-president of ETF institutional sales at Lyxor Asset Management, in September net inflows into bond ETFs were €671 million, and year-to-date sales were €20 billion for European fixed income ETFs. One reason why an investor may choose to hold bonds using an ETF, rather than directly holding the underlying assets, is liquidity. ETFs are only as liquid as the basket of securities they track – so most ETF providers choose indices that offer the greatest levels of liquidity. “ETFs are similar to conventional funds: they own underlying securities and their liquidity is driven by [those] securities. The nice thing about ETFs is, because they are broad and tend to be indexed, this means they’re broadly diversified,” says Ken Volpert, global head of fixed income indexing for Vanguard. An ETF may own thousands of issues, which means that the ETF is selling across a wide range of issuers and maturities to meet redemptions. Volpert explains this avoids having to place a concentrated sell order, which could create liquidity problems if the ETF had to.  This seems to put pay to the ‘herding effect’ that could potentially cause liquidity problems for bond ETFs. If a huge wall of passive money was invested in an ETF that held only a small number of bonds, than a mass redemption could cause liquidity issues even if the bonds themselves were investment grade and theoretically highly liquid. By tracking an index with a greater number of bonds, this is unlikely to happen. Another benefit of using an ETF to invest in bonds is that the bid/ask spread of the ETF will be much tighter than for the underlying bonds, says Volpert. This is due to the trading of the ETF itself. He analysed various bond ETFs to see how much of their trading volume led to creations – in other words, how many new bonds had to be bought. He compared this to the amount of buy and sell orders that had the effect of offsetting each other, and found that 90% of ETF trades were offsets, meaning there was not a need for creation and redemptions in the underlying basket.  This is also what keeps ETF prices accurate. “If the price gets too high [market participants] come in and do redemptions; if it gets too low, they’ll come and do creations,” he says. If investors were doing these transactions in the underlying bond market they would be paying a lot more in transaction costs, too, says Volpert. However, bond ETFs are still some way behind their equities counterparts. Fabrizio Palmucci, executive director, fixed income specialist at Source ETF, says: “Today relatively few market makers are able to truly understand the underlying bonds themselves and this is hampering the true potential of the fixed income ETFs as an instrument. As the market size grows, it is fair to expect more players within the market-making community becoming more active.” FROM EQUITIES TO FIXED INCOME
A conventional view is that passive investment works well for equities but more expertise – i.e. active management – is needed to navigate fixed income. Andrew Walsh, head of UBS ETF sales for the UK and Ireland, says this does not hold up under scrutiny. “The generally accepted view is that using passive for equity exposure is worth doing, but that fixed income really requires the expertise of an active manager,” he says. He adds, however, that evidence from S&P’s SPIVA score research found that a majority of active fixed income managers in key exposures struggled to beat their benchmarks after costs, although this was not as pronounced as with equities. Therefore there is a case to consider a passive approach in fixed income as well. Even in areas where a level of expertise would be crucial, such as emerging markets and high yield, after costs, even these more niche products failed to outperform.   CURRENCY EFFECTS
Fixed income ETFs have become more pervasive and there are few areas of the market that can’t be wrapped in an ETF package. Waterworth says a tremendous amount of bond ETF issuance has been seen in the past two years. Many product gaps have been plugged and bond ETFs now cover sovereigns, corporates and virtually any regional exposure, country and duration. As the level of international exposure increases, so does the currency effect. Currency hedging is a new area for bond ETFs and one that UBS is focusing on, says Walsh. “In foreign fixed income investing, currency movements have a disproportionate impact on performance as price and coupon returns tend to be a fair bit lower than equity returns,” says Walsh. Data provided by UBS shows currency returns more often than not outweighed both coupon return and price return for its Barclays US Liquid Corporates ETF when unhedged. However, UBS offer this product with range of currency hedges, including the Swiss franc and sterling. Waterworth of Lyxor says that the divergence between central bank monetary policy makes the argument for launching currency hedge ETFs stronger, especially in today’s low-yielding environment where currency fluctuations make a huge difference to returns. However, his firm does not offer any currency-hedged fixed income products yet. Bond yields are at historically low levels but, according to Walsh, data suggests there is still an appetite for bond exposure. This is because there are very few safe-haven assets. The question of the Federal Reserve’s interest rate rise has been on bond investors’ minds for some time, although Volpert does not think investors should be overly worried as the hike has largely been priced in. “I don’t think bond ETF investors should be that concerned right now as the US yield curve is quite steep. Look at the yields in the US compared to Europe, US ten-year [Treasuries] are at 200 basis points, UK [gilts] ten-year are 180 basis points,” he says.  He adds that most of the developed world’s bond yields are below that of the US and that, following suggestions by Mario Draghi, president of the European Central Bank, that the asset purchase programme of the bank will be increased, European sovereign bonds yields have moved downward. Towards the end of October, with news that the bank may increase its purchasing programme, German ten-year bond yields dropped 7 basis points (bps), French ten-year bonds dropped 9 bps and Italian ten-year bonds dropped 16 bps.   NEW PRODUCTS
If the fixed income market is as widely covered by ETFs as providers suggest, areas that may still need more coverage are duration and maturities.  Waterworth says there are few options for UK gilts, which presently come just short or long-dated. He suggests that this is an area where there could be more choices on duration. Volpert also thinks there could be more maturity categories, though he says that this has been happening for a while in US Treasuries.  Waterworth predicts that there may be more credit-rated bond ETFs released globally focusing on specific ratings, such as his firm’s recent high-yield ETF focusing on BB-rated companies in Europe.  These developments, such as increasing duration buckets, suggests that the European bond ETF market may become granulated in a similar way to the more mature US market.  Others would see a focus on higher-quality products as being progress. Palmucci, of Source ETF, says: “European investors use ETFs not only tactically but also as long-term investments. Quality matters here and, in that sense, there is scope for the current European offering to be improved and broadened so that fixed income ETFs on offer are comparable to the traditional mutual fund industry.” While the market may be at a slight impasse in terms of new product development in the bond ETF sector, investors look set to continue to pour money into fixed income ETFs. They like the ETF wrapper and the advantages it brings, such as liquidity and transparency. Waterworth says: ”If you think about the fixed income market, it’s opaque and has traditionally been traded over the counter. There’s low liquidity in individual bonds and this is coupled with a lack of standard benchmarks that you would find in equities. That’s why there’s a strong fixed income ETF market.” ©2015 funds europe

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