By Steve Sachs, Managing Director, Head of ETF Capital Markets, Goldman Sachs Asset Management
Fixed income ETFs are straightforward and transparent, offering highly liquid access to a core asset class and its sectors.
Fixed income ETFs are at nascent stage in development compared to the vast, global equities ETF market that has grown up in the last 25 years. However, their appeal to institutional investors has increased over the past five years, and accelerated as they are forced to respond to client requirements during the recent up-turn in the interest rate cycle.
There is now almost $700 billion in fixed income ETF assets globally. It’s a small proportion of the total $4 trillion market, but it is growing as investors have become more comfortable with different ETF vehicles. In the early days, they mainly comprised market-capitalisation weighted stocks linked to broad benchmark indices, then evolved to country-specific and niche vehicles, before maturing in sophistication to smart-beta strategies about five years ago.
Fixed income ETF development has lagged equity ETF maturation for several reasons. Primarily, the equity portion of a portfolio is typically inherently larger than the fixed income portion and thus the focus on ETF development has traditionally focused on this larger slice of the pie and greater need. While bonds traditionally play a risk mitigation and income generating role in portfolio construction, they have, in the post financial crisis landscape, also driven absolute return in portfolios. With the unwinding of accommodative monetary policies that is taking place globally now, investors are rethinking fixed income allocations and portfolio construction and demanding a more robust set of tools to build allocations. This is driving more demand for the next generation of fixed income ETF’s.
Fixed income ETFs driven by client demand
As the days of low interest rates and depressed bond yields are numbered, investors can no longer expect predictable returns in their fixed income portfolios. They are facing heightened duration risk, possible negative returns and exposure to credit events.
Moreover, the problems for US asset managers are exacerbated by the country’s demographics: an aging population requires wealth and income preservation, yet the conventional asset class for this phase in the investment cycle is fixed income.
Fortunately, bottom-up demand for a better way to gain exposure to fixed income markets has met top-down drivers of the ETF industry which promote mechanical efficiency, regulatory guidance and greater professional participation. Basel III, the Dodd-Frank Act and the Volker Rule restrict the warehousing of bonds by banks, leading to new intermediaries providing alternative sources of liquidity, facilitating the construction of fixed income ETF vehicles, which in turn have become a source of price discovery.
Trading in fixed income markets is robust, but it remains opaque and liquidity is fragmented and difficult to access at times. In practice, it is difficult to buy a large, broad portfolio of bonds, especially if the intention is to replicate a benchmark index or achieve diversification to mitigate risk. While this has improved over the past ten years as more technology has been applied to bond trading, challenges remain.
An ETF is an attractive alternative for many investors.
The ETF structure and its components are transparent and indices don’t need to be entirely replicated, as optimization lends itself well to fixed income portfolio construction. Other advantages of the ETF structure include lower dealing costs, greater tax-efficiency (in the US, because there is no capital gains tax payable), and, perhaps most importantly, they are tradeable as discrete units. Purchases and sales do not necessarily impact the value of the underlying fixed income securities.
Sale or redemption
Around $80 billion in ETF notional value are traded a day (including about $25 billion of fixed income ETFs), but only $10 billion is created or redeemed each day. For a sale, for instance, a dealer can hold the ETF in inventory, either taking an uncovered position or hedging their exposure. They can either find a buyer of the ETF, or might eventually redeem the ETF position with the issuer, who provides a basket of the underlying bonds in exchange.
Sometimes, the intermediary might use those bonds to construct a new ETF, warehouse the bonds as inventory, or simply sell the bonds. The idea is that the dealer has choices in which to mitigate risk and find liquidity.
Investors can take advantage of this flexibility. For example, an insurance company might hold a high yield ETF to gain immediate exposure and earn incremental yield, then redeem the fund through a dealer and take delivery of the underlying bonds.
Fixed income ETFs, like equity ETFs, benefit from the dual layers of liquidity that exists: secondary market and primary market liquidity. These two layers work together to not only provide liquidity, but also the ability to arbitrage any price difference between the two, thus keeping secondary market prices in a normal fair value range.
Of course, investors can always build a fixed income bond portfolio directly, with individual bond selections. However, there is a trade-off between costs and access, implementation and efficiency.
At this stage, most fixed income ETFs are linked to broad benchmark indices, which is a constraint for investors that require more specific or thoughtful exposures. Niche fixed income ETFs are in the early stages, with issuers and providers examining the potential for a next generation of products, such as smart beta fixed income ETFs. In the future, we may see this continue to evolve as the market responds to the ever-changing needs of the investors in the asset class.
Fixed income ETFs are straightforward and transparent as well as offering highly liquid access to a core asset class and its sectors. The structures and investor choices will evolve as the client demand determines and as an ecosystem of participants, their skills and experience, grows.