Answering the call for fixed income ETF innovation

Feb 5th, 2021 | By | Category: Fixed Income

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By Lidia Treiber, Director, Research, WisdomTree.

Lidia Treiber, Director, Research, WisdomTree.

Lidia Treiber, Director, Research, WisdomTree.

The last few years have delivered different fortunes for fixed income ETFs.

2019 was a turning point as flows hit new historical highs as investors began shifting allocations to the ETF wrapper. While the bulk of assets in the bond world still sit in active funds, ETFs have allowed providers to deliver innovation within fixed income, and that trend is unlikely to reverse.

The ETF wrapper has made difficult to access asset classes more accessible than ever, and also provided the building blocks necessary for investors to construct diversified portfolios in a transparent and easily tradeable vehicle.

ETFs arguably offer investors the most innovative and efficient wrapper for fixed income products. The ability for ETFs to take bonds ‘in kind’ reduces trading fees by not having to go out into the market to buy or sell underlying bonds each time there is an order. This, coupled with the effect of having a secondary market where investors benefit from two layers of liquidity, without having to deal in the primary market, demonstrate some of the beneficial features of bond ETFs.

But could a lack of innovation halt the growth of fixed income ETF adoption?

While the ETF wrapper has supported innovation, fixed income in itself is not widely regarded as an innovative asset class. However, the Covid-19 pandemic gave birth to a new fixed income asset class, EU bonds, designed to tackle the virus and stimulate an economic recovery in the Eurozone. The expected European Union bond issuance will see the EU become the second-largest AAA-rated issuer in Europe, transforming the supranational space.

We have seen investors gain exposure to the full spectrum of fixed income asset classes using ETFs, but only a limited number of investors are intending to increase their fixed income allocations over the next 12 months. Despite a shift towards fixed income ETFs in recent years, under 15% of investors actively consider the ETF vehicle when deciding to allocate to fixed income. So, has fixed income ETF adoption reached its pinnacle, and is more innovation required to continue its growth trajectory?

In recent years, we have seen more market access tools appear in Europe, ranging from cost-effective ways to gain exposure to AT1 CoCos and floating-rate US Treasuries. The bond market continues to evolve with new asset classes forming, and investor behaviour shifting towards environmental, social, and governance (ESG) options. ETFs are likely to keep pace with this evolution and provide market access to these new asset classes meanwhile innovating existing asset classes by promoting more ESG-friendly practices among bond issuers. Looking specifically at EU bonds, all bonds issued under the SURE programme fall under the social bond framework and a portion issued under the Next Generation EU initiative could fall under social or green bond frameworks.

Despite evolution within the fixed income space, the bulk of fixed income assets sit within market cap-weighted indices, providing investors with pure beta exposure. Over half (53%) of European financial advisers use bond ETFs to reduce the total expense of a portfolio. The cost-benefit of ETFs has long been discussed, but this cannot be at the expense of performance, and here is where innovation can help.

In today’s fixed income markets, the ability for investors to maintain the appropriate balance between risk and return remains extremely challenging. In more normal interest rate environments, an investor’s core bond holdings could be relied on to generate income and help mitigate volatility from other riskier asset classes. Given that many investors often follow market-capitalisation weighted benchmarks, yields on their holdings have typically decreased over the years. Such decreases in yield often come at the cost of their ability to generate sufficient income from core portfolios. Innovative solutions like indices with yield optimisation mechanisms can enhance yields while keeping risk in line with a familiar benchmark. Enter smart beta ETFs.

Smart beta ETFs account for around 3% of assets in European-domiciled fixed income ETFs. After originally piquing the curiosity of investors, fixed income smart beta products had a rough 2019 as flows went to market-cap-weighted and active ETF strategies. The story was somewhat shifted in 2020 with smart beta ETFs taking in more than double the flows seen in active ETFs. Often overlooked, these innovative solutions can balance the returns and cost efficiency investors are looking for. Our research highlights that 31% of fixed income ETF allocations by European advisers is in the high yield bond market, yet an index with a yield optimisation mechanism could be a useful tool to gain access to the high yield bond market. Some smart beta ETFs offer ways to filter the universe of high yield bonds to exclude companies with the lowest credit rating which may have a higher likelihood of defaulting. Adoption of smart beta fixed income ETFs has only scratched the surface, but the innovation investors are seeking might be just around the corner, or it could already be here.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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