Piyasi Mitra explores the dynamic world of bond ETFs, unveiling their appeal and strategic importance in a fluctuating economic climate.
In 2023, investors relocated from equities to fixed income, motivated by heightened risks in risk assets, economic growth concerns and central banks’ robust response to price pressures. This shift follows a decade of low-to-negative interest rates, presenting attractive entry points in government bonds and investment-grade credit. How, though, are these changing market dynamics influencing the strategies of both individual and institutional investors in bond ETFs?
Front end of the curve
Recent bond market volatility and ongoing bear-steepening at the curve’s long end suggest increased stability at the front end, partly due to the ECB indicating an approaching end to its policy tightening. According to Jason Simpson, fixed income SPDR ETF strategist, State Street Global Advisors, shorter maturities are less sensitive to heavy supply and provide higher yields than longer maturities due to the inverted curve.
This results in a “historically strong” yield-to-duration ratio at the front end of the credit curve. Simpson explains this metric is “vital” because it suggests that yields would need to increase significantly before the price losses on the fund outweigh the annual yield.
ECB’s relentless rate rises have seen the short end of the curve move from negative yielding at the start of 2022 to yields comfortably above 4%. Unsurprisingly, there was limited investor demand for negative-yielding assets. However, with returns on short-dated bonds now “more interesting”, the industry is witnessing the launch of some Euro-denominated short-maturity ETFs, explains Simpson.
Amid growing pessimism and revised monetary policy outlooks, investors favoured the shorter end of the yield curve, and many of the most popular bond ETFs in the third quarter resembled cash-like alternatives, highlights Jose Garcia-Zarate, associate director of passive strategies research at Morningstar Manager Research.
“Investors are increasingly opting for local bonds, driven by attractive yields – a strong trend in Italy.”
Investors favoured government bonds, with Euro government bond ETFs drawing over €3.2 billion, followed closely by US dollar government bond ETFs with the same amount. UK government bonds also ranked among the top 10 money-attracting exposures in the third quarter.
Strategies for portfolio safeguarding
Caroline Baron, head of EMEA ETF distribution, Franklin Templeton, cites Morningstar data indicating that the fixed income category scored quite highly, securing 43% of the flows. “Lately, flows have been stronger on the EUR government category at the expense of the EUR high yield – possibly indicative of a flight to safety amid volatility,” shares Baron.
“Investors are increasingly opting for local bonds, driven by attractive yields – a strong trend in Italy. Additionally, there’s a willingness to extend portfolio duration to capture higher yields,” adds Baron.
As interest rates peak, there could be some movement on the longer duration side, she explains, even though the curve is flat for now, indicating that investors may not be necessarily rewarded for taking on duration. “We’ve noticed this trend in conversation with clients who are interested in making their portfolios more environmentally friendly with ongoing discussions regarding the Franklin Sustainable EUR Green Bond Ucits ETF across Europe. There’s also a division regarding extending duration or staying on the shorter end,” she adds.
Investors might look at longer duration funds if interest rates are peaking and start building pockets on the sovereign and corporate side – depending on their anticipation, envisages Baron. “Overall, there will be a focus on quality and reducing risks in light of the year-end which points to selecting more actively managed strategies as they will be able to quickly adapt to the markets we are in.”
Investment grade zone
Vincent Denoiseux, head of investment strategy at Amundi ETF, Index and Smart Beta, points out that in September, total net new assets on the European ETF market reached €102 billion year to date, with nearly half (€46.6 billion) invested in fixed income ETFs.
Developed markets government bonds have been the most popular asset class within the bond ETF segment, gathering over 50% of the net new assets (NNA). In Q3 2023, this touched 85% (€11.9 billion) of total NNA in the bond asset class, he adds.
“The corporate bond segment remains the most represented, with ETFs replicating general ESG strategies, as well as climate solutions tracking climate transition benchmark or Paris-aligned benchmark indices.”
“The corporate bond segment remains the most represented, with ETFs replicating general ESG strategies, as well as climate solutions tracking climate transition benchmark or Paris-aligned benchmark indices,” shares Denoiseux.
Fixed income flows for 2023 have focused quite heavily on Euro-denominated investment grade corporate debt, with around € 9.0 billion of inflows into ETFs year-to-date, points out Simpson. Investment-grade credit offers better returns than government bonds. This is particularly important for European investments since the companies in this category should maintain stable financial health, especially during economic weakness, he adds.
Greening the space
Baron anticipates that investors will still need to implement sustainability on the fixed-income side of the portfolio after carrying significant work on the equity side. She cites her firm’s offerings comprising Article 8 or 9 funds – an area she believes will keep growing as this is just “the beginning of the movement on greening the fixed income space”.
Total assets in ESG bond ETFs increased to €72 billion from €70 billion, constituting 21% of all assets invested in European bond ETFs. According to Garcia-Zarate, within these, the small group of ESG bond ETFs—11 funds—in the euro government-bond category attracted €1 billion, of which close to €0.7 billion went to the Amundi Euro Government Tilted Green Bond ETF, which follows an index with a minimum 30% allocation to green bonds.
“Integrating ESG criteria into traditional sovereign bonds is challenging, making it unsurprising that investors turn to green bonds as a straightforward way to add sustainability to their sovereign bond allocations,” shares Garcia-Zarate.
“Integrating ESG criteria into traditional sovereign bonds is challenging, making it unsurprising that investors turn to green bonds as a straightforward way to add sustainability to their sovereign bond allocations.”
Flight to quality
Investors who underestimated the speed of key rate increases and the Eurozone’s economic struggles have suffered due to their misjudgement of subsiding inflation. This miscalculation has stung them amid the anticipated “return of the bond” in 2023, says Kamil Sudiyarov CFA and ETF product manager, VanEck.
“Despite that, many started recently positioning themselves on the longer side of the duration spectrum, with a large chunk of the inflows going into the 7-10 years maturity basket and a fair share of investments in the 10+ category,” he adds. “This possibly signals a belief that the developed world central banks would struggle to further raise rates or be forced to lower them in the face of economic weakness.”
There was also a noticeable “flight-to-quality” from EUR corporate bonds into EUR sovereign debt, highlights Sudiyarov. The last quarter also saw noticeable inflows into gilts, somewhat reversing the fortunes of the asset class scarred by the UK budget in September 2022. The weakening pound and expectation of rate cuts in the 2nd half of 2024 have buoyed some investors betting on the price appreciation of the bonds.
Ace with “Active”
Travis Spence, head of EMEA ETF distribution, J.P. Morgan Asset Management, highlights how European investors are re-thinking allocations to core fixed income, focusing on Ucits fixed income ETFs. During 2022 and YTD 2023, fixed-income ETFs have taken in over 40% of the total net flows of ETFs despite representing just 25% of the market by assets.
According to Spence: “With yields at their highest level in a generation, investors in core fixed income can earn higher income while reducing portfolio risk and provide a valuable hedge to late-cycle volatility.”
“With yields at their highest level in a generation, investors in core fixed income can earn higher income while reducing portfolio risk and provide a valuable hedge to late-cycle volatility.”
Active strategies are well-suited to fixed-income ETFs, he says. Additionally, bond indices prioritise the largest issuers over the most successful ones, unlike equity indices. According to Spence: “Actively managed fixed income ETFs have the flexibility to shift towards more reliable issuers and away from potential downgrade risks, thereby safeguarding capital and returns during market challenges. Active management is valuable in navigating curve and duration risks, especially in the current context of highly active central banks.”
Beyond “vanilla”
The European ETF industry enjoyed healthy inflows throughout 2023 so far, which are already well above 2022 inflow levels overall and may reach the level of the record flows witnessed in 2021 by the end of the year, says Detlef Glow, head of EMEA research at LSEG Lipper.
The first nine months of 2023 were driven by equity ETFs (+€56.7 bn), followed by bond ETFs (+€41.1 bn), money market ETFs (+€6.7 bn), commodities ETFs (+€0.9 bn) and mixed-assets ETFs (+€0.5 bn). Conversely, alternative ETFs were the only asset type facing outflows over the first three quarters of the year, according to Glow.
Expecting the European ETF industry to witness more bond ETF launches to meet investor demands, Glow estimates that while some will be “vanilla” offerings, most new ETFs will target specific segments like single ratings, maturities, convertibles or green bonds in various currencies.
Additionally, he anticipates more specialised ETF providers offering advanced bond strategies for professional and institutional investors looking to diversify beyond conventional approaches. Glow expects specific bond ETFs focused on individual rating segments, maturities or maturity bands to draw interest from these investors. These can serve as substitutes for individual bonds, providing a comparable risk-return profile while mitigating single bond issuer risk, Glow adds.
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