Will rising rates slow the organic growth of bond ETFs?

Jan 4th, 2017 | By | Category: Fixed Income

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Despite record low interest rates offering little enticement to yield-hungry investors, 2016 will be remembered for record levels of bond issuance and large flows into corporate bond exchange-traded funds. However, with interest rates beginning to normalise, these trends may begin to change.

Will rising rates slow the organic growth of bond ETFs?

Following the Federal Reserve’s December meeting, the Federal Open Market Committee increased their projections for the number of interest rates in 2017 from two to three.

According to latest figures from BlackRock, global investors poured $33.6bn into investment grade corporate bond ETFs and $7.4bn into high yield corporate bond ETFs in 2016 until the end of November. In Europe, total assets in corporate debt ETFs have increased by 39% over this period to €60.4bn, according to Deutsche Bank data.

The top two fixed income ETFs in Europe in November in terms of inflows were both corporate-bond focused. The iShares Euro Corporate Bond Interest Rate Hedged UCITS ETF (LON: IRCP) attracted €319m in new money and the Amundi ETF Floating Rate USD Corporate UCITS ETF – Hedged EUR (PARIS: AFLE) saw €272m in net gatherings, found Deutsche Bank.

The large flows into fixed income ETFs have been driven by a greater awareness of the structural benefits offered by the ETF vehicle including diversification, lower cost and ease of tradability. This has resulted in increased usage of the funds as broad long-term holdings as well as greater use for short term tactical plays.

With interest rates at record lows, borrowers also used this opportunity to issue a record level of debt during 2016, with $6.6tn worth of new bond issuance breaking the previous record in 2006, according to Dealogic.

Corporate bond sales led the pack in terms of debt issuance, climbing 8% year on year to $3.6tn, as firms increased their leverage in the wake of negative interest rates adopted by central banks in Europe and Japan. The widely-followed 10-year US treasury yield hit a record low of 1.32% in July.

“The low cost of financing with record-low interest rates simply made building up leverage tempting,” Scott Mather, chief investment officer for core fixed income at Pimco, told the Financial Times.

But since businessman Trump won the presidential election on 8 November and promised to cut taxes and create fiscal stimulus, the 10-year US Treasury yield – an important benchmark for borrowing costs – has jumped to 2.57%, signalling the next stage of the credit cycle is well underway.

With the Federal Reserve raising interest rates in December and, perhaps more significantly, increasing their expected number of rate hikes for 2017 from two to three, the anticipation of falling bond values from rising yields is likely to reduce demand for fixed income securities.

This trend may begin to dampen the momentum behind the current strong net inflows into corporate bond ETFs. Although it is yet unclear which categories of ETFs will be most affected, one may suspect that ETFs with longer durations may see the sharpest turnaround. If investors perceive the increase in yield to be attributable to rising risk, high yield corporate bond ETFs and those targeting emerging market sovereigns may also see reduced demand.

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