While demand for fixed income ETFs has more than doubled since 2018, the product still occupies only a fraction of the market share for the category. Alex Rolandi examines the reasons.
Although assets of Ucits ETFs are largely concentrated in large-cap stocks, this year’s annualised net share issuance of fixed income and allocation funds in Europe stood at €36 billion through August 2019, compared to equities at €12 billion, according to Morningstar.
There are arguably not enough solutions to meet this demand, says Legal & General Investment Management’s (LGIM) head of ETFs, Howie Li. Until more options are available, he says, a bias towards equities can be expected.
“Fixed income ETFs are a huge growth opportunity. It’s where the development of the ETF industry needs to be focused over the immediate term,” he tells Funds Europe. “As an asset class, fixed income is much bigger and more complex than the equities market.
“If you look at some of the stats, you have year-to-date more than 80% of net new assets into fixed income. That goes to show as a trend, people are seeking out fixed income ETFs.”
Look at Morningstar’s best and worst-performing global ETFs and the trend becomes clearer. Six out of the ten bestselling funds were fixed income-focused, while nine of the ten worst-performing were equities as of the end of August this year.
Developing new indices
For Deborah Fuhr, founder of research firm ETFGI, it’s all relative. Fixed income products came relatively late to the ETF market – for the first nine years, all products were equity-focused.
In many cases, the tools at hand to analyse fixed income products are more geared towards equities analysis, according to Fuhr.
“You have fewer index providers when it comes to fixed income benchmarks. Bloomberg is one of the dominant fixed income index providers, having bought what used to be Lehman then Barclays indices. Having fewer index providers and indices is one of the reasons you don’t have the same breadth and depth of products that you see in equities,” she says.
But developing an index doesn’t happen overnight. Even though a number of index providers are trying to create fixed income indices where they haven’t seen them in the past, it is still a growth space. “For people to use indices, they want to see historical data. That’s part of the challenge – cleaning up the historical data,” says Fuhr. The fact that Europe still doesn’t have a consolidated tape for ETFs, she adds, is also a cause for concern for those investors who are worried about pricing or believe the vehicle isn’t liquid.
LGIM’s Li agrees that there is a need for greater index development in the fixed income ETF space. “Investors have been asking for more choice and innovation in fixed income ETFs as they recognise that there can be better solutions than indices weighted purely based on the amount of debt issued,” he says.
“Bonds are a very large universe and corporate bonds in particular can benefit from more analysis. A deeper analysis of variables that may consistently affect performance, risk or liquidity can help bring innovation to fixed income indices that can be used in ETFs.”
Despite the comparative lack of tools, fixed income can still be seen as a safe haven during times of volatility. Interest rates are low and many developed government bonds are trading with negative yields – but this doesn’t undermine the perceived safety of fixed income instruments relative to equities, says Morningstar’s associate director of passive strategies research for Europe, Jose Garcia Zarate.
Looking at the geopolitical landscape – with trade wars, Brexit twists, bearish central banks and more – it is no surprise to see investors de-risking. “Whether one likes the low interest rates or not, safety still means bonds,” he says. “There is, of course, a debate to be had about the wisdom of piling into negative-yielding government bonds, but many of the flows are actually going to investment-grade corporates and emerging market debt, which still offer above-zero yields.”
Garcia Zarate believes that, further down the line, an ageing population could also play a role in the balance between equities and fixed income flows. “Bad demographics is the white elephant in the room for many European countries,” he says. “In time, the proportion of the population favouring bonds as their default core investment may outweigh that of equity (aka Japanisation).”
A report earlier this year by ETF provider Tabula Investment Management found professional investors are looking to increase their fixed income exposure over the next three years, with a growing number planning to use ETFs to access the asset class.
The average percentage of investors’ portfolios invested in bond ETFs is expected to rise from 7% to 12% by 2022, while the number of investors with 10% or more of their fixed income exposure in ETFs is set to double from 16% to 33% during the same period.
Stressed periods
Despite this ever-increasing interest in fixed income ETFs, the investment vehicle can often be misunderstood. According to VanEck’s head of fixed income ETF portfolio management, Francis Rodilosso, there’s concern in the fixed income world of promised very high intra-day liquidity at tight bid offer spreads.
A common criticism he hears is that, in periods of stress, the secondary market in bonds breaks down and the promise of liquidity in ETFs is false and will cause a blow-out. However, he notes that the fourth quarter last year provides an example of the ETF dynamic and what can happen in stressed periods.
“Credit spreads moved wider pretty rapidly, and fairly significantly, from just over 300 basis points over treasuries on US high yield to well over 500 basis points during the fourth quarter. Secondary market trading volume in cash bonds fell precipitously during this time. But, importantly, trading volume in fixed income ETFs, including high yield bond ETFs, accelerated,” he says.
“ETFs actually became liquidity vehicles. They also became price-discovery mechanisms and had various other uses: people hedging exposure, people wishing to reduce their overall exposure to high yield and had ETFs as part of their high yield allocation, people looking to add exposure were willing to provide bids, add exposure tactically, or strategically.”
When the trading price of ETFs relative to their net asset value moved into discount territory, the next criticism would be that investors aren’t getting the same liquidity, because the price of high yield ETFs has slipped below net asset value, he says.
A fund’s valuation is based on an estimation by pricing services of where market prices are for cash bonds. “But if cash bonds aren’t trading a lot, then that net asset value can become stale or slow to react, and the ETFs themselves become the better measure of where prices are.”
Tactical strategies
Li explains that fixed income ETFs are increasingly used as a single trade diversification tool, and that they save some investors looking to buy and sell single lines of bonds. As a house, LGIM predicts more instability over the next 12 months or so. Where volatility is concerned, investors will want to look at fixed income, he says. While worries grow about the macroeconomic landscape, greater numbers of investors are using ETFs as long-term holding tools.
“Before, ETFs were really seen as tactical tools only. In the last five or six years, it’s been widely recognised that you can use them as strategic long-term holds as well as tactical. We’re starting to see some investors say they’re moving everything to ETFs – for them, it’s about having that transparent pricing, that transparent lower-cost investment model,” Li adds.
When there is market volatility, this transparency generates a lot of interest in this investment vehicle from the financial press and investors, says VanEck’s Rodilosso.
“ETFs are what you might look at if you want to know how credit markets are doing intra-day or how volatile they have been – ETFs are a good vehicle to see how it’s going, but there’s a difference between being a symptom of the problem or a cause of the problem,” Rodilosso says.
According to the fixed income manager, ETFs are a primary source of information for whatever is going on in the market. But when things aren’t going well, it can give ETFs the image that they are leading the volatility.
“People concerned about ETFs, or who might hold the notion that ETFs are going to lead to some kind of calamity, ignore the fact that these are generally very straightforward, very transparent non-leveraged structures,” notes Rodilosso. Much of the criticism, he says, comes from active managers.
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