Innovator extends defined-outcome strategy to bond ETFs

Aug 17th, 2020 | By | Category: Fixed Income

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Innovator Capital Management is set to become the first issuer to launch defined-outcome bond ETFs with two listings pending on Cboe BZX Exchange.

Innovator extends defined-outcome strategy to bond ETFs

Innovator extends defined-outcome strategy to bond ETFs

Similar to their equity counterparts, the new funds will protect investors against a pre-determined amount of potential losses over a specific outcome period.

But instead of equities, the funds’ exposure will be to long-term US Treasury securities, as represented by the iShares 20+ Year Treasury Bond ETF (TLT US).

The funds are the Innovator 20+ Year Treasury Bond 5 Floor ETF – July (TFJL US), which will provide the upside price performance of TLT to a cap and a maximum loss of 5% over the outcome period, and the Innovator 20+ Year Treasury Bond 9 Buffer ETF – July (TBJL US),  which will provide the upside price performance of TLT to a cap with a buffer against the initial 9% of losses over the outcome period.

The ETFs gain their desired exposure by investing in customizable FLexible EXchange (FLEX) Options on the iShares 20+ Year Treasury Bond ETF, which was chosen for its deep and liquid options market. The ETF tracks the ICE US Treasury 20+ Year Bond Index which consists of fixed-rate US Treasury securities with maturities greater than 20 years. The index currently has an effective duration of 18.87 years.

The downside protection within the ETFs comes at the expense of a cap on the potential upside over the outcome period. The cap for each fund is set at the beginning of the outcome period and is dependent upon market conditions at that time.

While the current caps for the ETFs will not be known until the funds go live, Innovator expects the cap on the 5% floor ETF to be between 5.57%-7.00%, while the 9% buffer ETF will have a cap between 6.08%-8.25%.

The ETFs will have outcome periods of one year ending in July 2021.

At the end of the outcome period, the ETFs will rebalance and reset, providing investors with a fresh floor of 5% and buffer of 9% as well as new upside caps dependant on market conditions at that time. The perpetual nature of the ETFs makes them suitable as long-term portfolio holdings.

Each defined-outcome bond ETF comes with an expense ratio of 0.79% and is anticipated to be as tax-efficient as traditional bond ETFs with investors being able to defer taxes until selling.

Innovator has announced its intention to expand the series with a pair of ETFs that have one-year outcome periods expiring in January.

Innovator’s defined-outcome equity ETFs have been highly successful with the suite housing over $3bn in assets under management across S&P 500, Nasdaq 100, Russell 2000, MSCI EAFE, and MSCI Emerging Markets product lines.

Demand has been particularly strong this year with more than $1.2bn net inflows year-to-date from investors seeking in-built equity risk management amid the uncertain Covid-19 market environment.

Whether a line of fixed income buffer ETFs can replicate that success remains to be seen as advisors may not consider defined-outcome investing to be as intuitive for bonds compared to the highly volatile nature of the stock market.

The ETFs are, however, launching at a time when their potential appeal is amplified. Interest rates are currently at historic lows, bond prices are near record highs, and duration risk – a measure of the sensitivity of bond prices to changes in interest rates – is increasing.

Bruce Bond, CEO of Innovator ETFs, commented, “We’re very excited to bring the benefits of defined outcome ETF investing to the bond market and chart another completely new category in the ETF world.

“Today, advisors are faced with some of the highest risk bond markets in history which is compelling many to rethink conventional wisdom when it comes to the core of their debt allocations. Institutional investors have several tools to hedge against risks in bonds but advisors have very few. With the listing of these new defined outcome bond ETFs, advisors will have some of the same sophisticated tools available to institutions but in the liquid and tax-efficient ETF structure.

“We think Innovator’s defined outcome bond ETFs will provide significant potential improvements to all advisors with bond allocations by removing some of their clients’ exposure to the substantial interest rate tail risk. TFJL and TBJL can be implemented as part of a core bond allocation to mitigate downside risk while still maintaining some of the upside performance potential.”

John Southard, CIO of Innovator ETFs, added, “With rates approaching zero, bonds are increasingly bought for diversification, not income. But with durations extending and bond risks rising, advisors are now seeking to add a measurable buffer to the ‘safe’ side of their portfolio.”

“For decades, long-term US Treasuries have exhibited a strong negative correlation to equities, especially in periods of stress and negative returns for stocks. This negative correlation to stocks provides a strong case for long-dated US government debt in a portfolio setting.

“Yet, with more duration comes more volatility which can make owning Treasuries further out on the curve tough to stomach. This vulnerability is magnified today with rates in a position where there is a lot more room to move up than down. And with the twin engines of fiscal and monetary policy currently creating money like never before, many worry inflation could materialize substantially over the mid-term.

“With defined-outcome bond ETFs, Innovator intends to help advisors and investors solve this challenge by providing core bond ETF solutions that seek to limit loss while maximizing the potential diversification benefits of the asset class.”

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