At the start of 2015, many investors believed rising interest rates would be a headline story. But at the halfway point in the year, the reality has been rather different.
While central banks in the US and the UK have yet to raise rates, more than 20 central banks have eased monetary policies or cut their interest rates in the past six months.
Moreover, in Europe the unprecedented bond purchase programme by the European Central Bank (ECB) led interest rates past zero and into negative territory in Switzerland, Denmark and Sweden. In terms of yields, until recently investors had seen a ‘pull to zero’ in government bond yields. Since March, the ECB has been buying €60bn (£43bn) of bonds each month.
This has created a supply and demand imbalance, with the ECB’s purchases exceeding 100 per cent of the issuance of German government bonds. The volatility witnessed more recently in government bond markets has served to remind investors of the risks present in today’s low-yield environment.
In the second half of the year, we expect to see the focus shifting to a tightening of monetary policies and a possible US rate rise in September. While recognising that many assets seem increasingly fully valued – take the search for yield – put simply, there is a shortage of quality fixed income assets. Investors are finding this a challenge, particularly in Europe, as the trickle-down effect from the quantitative easing purchases has led investors to move into investment-grade and high-yield corporate bonds.
This is borne out in the flows into exchange-traded products (ETPs), of which exchange-traded funds (ETFs) are the largest category. The latter saw record inflows in 2014 and through the first four months of 2015.
For liquidity and diversification reasons, an increasing number of professional investors are turning to ETFs to access fixed income markets. In the first five months of 2015, investors globally were targeting yield as shown by flows of $8.4bn into high-yield corporate bond ETFs and $14bn into investment-grade corporate bond ETFs.
By historical standards, bond issuance has been high, with investment-grade corporate bond issuance in the US on course to top 2014’s record. In Europe, meanwhile, non-European companies have been taking advantage of extremely low absolute funding rates. More non-European issuers and more longer-dated issuance mean investors should have new opportunities to own long-dated paper at attractive spreads.
But in the secondary market, liquidity has worsened as a result of structural shifts and regulations. Issuance may be strong but liquidity, as measured by trading volumes and average trade size, has been in decline since 2007.
Some of the reforms enacted since the financial crisis have led to a reduction in the amount of capital banks and brokers can commit to trading bonds, in turn reducing the tradable supply of the asset class.
As a result of this, new investors are using fixed income ETFs. For larger investors, the fact that many of these funds have increased in size and liquidity make them increasingly useful tools for efficient trading. Furthermore, the ability to target specific parts of the market in a single trade is attractive for an increasingly broad range of investors, whether they are seeking yield or a relative safe haven.