FIXED INCOME: Black clouds for fixed income

Demand for fixed income ETFs is high but there may be significant product gaps in the market, finds Nick Fitzpatrick. Investors need these filling as the possibility of interest rate changes looms.

Fixed income investors are at a crossroads. Some fear a low interest rate environment extends before them, while others fear an environment of rising rates. Uncertainty lies in both directions because either situation is challenging for fixed income asset classes. 

The pressure is on index and ETF providers in Europe to present investors with choices. 

“The current ‘menu’ is pretty extensive but missing some tools investors might be able to leverage,” says JR Rieger, global head of fixed income indices at S&P Dow Jones Indices (SPDJI).

Rieger gives examples of product gaps: ETFs that target specific maturity years for duration and liability matching; senior bank loans for their floating-rate characteristics; multi-sector offerings that can help diversify exposures. All seem to be missing components of the European ETF offering, he says.

But ETF providers rely in indices – and index providers such as SPDJI. Without an index, there is no ETF.

SPDJI has, in recent years, developed global sovereign and corporate fixed income indices. These are index standards, of course. But with more demand for strategic indices, the index firm has also developed an inflation-linked index series. 

Rieger says that though inflation may not be of a big concern at present in developed countries, fiscal measures the European Central Bank (ECB) is taking, as well as tapering of quantitative easing in the US, could change the direction of growth and rates. 

“Inflation is always a concern when such changes occur and the appeal of such products will grow. Rising rates are a black cloud for fixed income.”

Consequently, floating-rate products that have incremental yield are in demand because the senior bank loans they invest in form an asset class that offers both floating rate characteristics and yields that can be attractive, Rieger says.

Fixed income is about one-third of net new money invested in ETFs this year and it is still growing, says Matthieu Guignard, global head of product development and capital markets at Amundi ETF and indexing.

Are investors satisfied by fixed income ETFs? Not currently, he says, but this could be about the fixed income offering as a whole, rather than specifically ETFs.

“It is a challenge to gain yield without taking too much risk. The market as a whole is a very big challenge for investors,” comments Guignard.

Many investors in Europe realise that a low point for yield has been reached in many countries, particularly at the core of Europe, if not the periphery, he adds. 

“Some investors fear a very low rate environment for some years; others fear we may be entering a rising rate environment. Both situations are pretty challenging for fixed income asset classes.”

In September, Amundi launched the Floating Rate Euro Corporate 1-3 product, an ETF designed to offer “good yield with low sensitivity to interest rate rises” with a Euribor 3-month reference. Guignard says this is a part of how Amundi has adapted to the changing fixed income market. Previous products included an ETF that invests in sovereign debt in the riskier eurozone countries, such as Spain and Greece.

“Many investors realise we may have reached some kind of low point for yield in many countries, most specifically in the core if not the periphery [of the eurozone].”

The challenge for fixed income ETF providers and index makers has evolved over the last couple of years. Six years ago, Guignard says, the eurozone fixed income market was really uniform, with strong correlation between countries and little difference between spreads. Since the sovereign debt crisis, the market has evolved in different directions. The peripheries, such as Spain, became more risky. But over a further period of time the peripheries came to be seen as less risky. 

They became the places to go to obtain yield with an attractive level of risk, says Guignard.

“We are still in that period – the periphery is still one of the best places in fixed income to get yield with an acceptable level of risk.”

He says that when the sovereign debt crisis began, people got rid of Italian, Spanish and, of course, Greek bonds. 

However, after ECB measures showed there was a strong political will to save the euro, debtors were reassured and started to buy back bonds. Spreads have since tightened.

“When we issued it [the periphery ETF product] we were in the middle of the periphery crisis and many people thought we were mad. But for us it made sense to issue ETFs for both the highest and lowest rated fixed income exposure. The beauty of ETFs is they are there for different market cycles.” 

The product has $1.9 billion (€1.5 billion) of assets and is a “best seller”, Guignard says.

Jean-Rene Giraud, the chief executive of Koris International, which tracks ETF risks and performance, says that though the fixed income ETF offering in Europe is “pretty wide”, the current level of maturity in the market makes it difficult to compare fixed income ETFs.

He adds: “In the fixed income universe, there are myriads of different indices, each tracked by only one or two funds,” he says.

Whereas there are 25 ETFs tracking the S&P 500 equity index, there are only “two or three at best” on most fixed income indices, such as the Iboxx family.

“It is an issue because this does not give you much in order to compare the tracking quality between ETFs.”

But there is at least some evidence to suggest that fixed income ETFs do track their indices as well as equity ETFs, Giraud says. “We did a study of investment grade bonds in July and fixed income ETFs clearly track indices very well, as well as equity indices.”

Rieger, at SPDJI, has a different view. He says: “As fixed income ETFs are still in their infancy, it is yet to be seen if it will have similar tracking patterns to the equity market.  Fixed income is a combination of over-the-counter (OTC) asset classes. Depending on the particular asset class and market conditions, tracking error in ETF products can vary most in periods of bond market stress.”

Giraud, at Koris, does say that index tracking quality for ETF trading purposes can be a problem. The small size of volumes in the secondary market mean larger trading transactions need to go to the OTC market. 

“In the OTC market it becomes much more complex to know what drives the ETF price. The OTC world is not known to be transparent. Premium discounts and spreads are probably more complex to understand and measure. Understanding what you pay and why is a complex game.”

The Markets in Financial Instruments Directive was supposed to force people to report transactions but the regulator’s constraints are not sufficiently binding, says Giraud. “The regulator is now imposing tougher rules but still expects the solution, a central trade repository, will be industry led.”

Banks are large players in the fixed income index market, more so than in equities, where major equity index providers, like SPDJI and FTSE, are independent. The issue of price transparency is inevitably important where a bank is both providing an index and pricing the underlying securities. 

Guignard, at Amundi, says: “We try to choose a provider that is independent from one specific bank. EuroMTS and Markit Iboxx [which Amundi uses] are platforms that have multi-contributions for pricing and are transparent. Multi-pricing sources are better than taking prices from one bank.”

For a sign of how the European fixed income market may develop, it could be useful to look at the US. The US has a proliferation of fixed income offerings including products tracking the very long-term bond market and intermediate, short and ultra-short duration aspects of the fixed income market, comments Rieger at SPDJI.

Nevertheless, even in the US the market is in its early stages. 

“Fixed income ETFs are still in early stages of development with a trend moving from your standard offerings of government and corporate indices to that of more strategic indices.  Investors are looking for a more tactical approach for matching benchmarks in ETFs. 

Themes like smart beta, alternative weightings and target duration indices are gaining in popularity.”

©2014 funds europe



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