Fixed income investing requires skill and market knowledge, and so investors should not overlook the benefits of investing in passive strategies when considering the bond markets.
Given tight dealing spreads, lower costs and liquidity, the exchange-traded fund (ETF) market is certainly an investment strategy that deserves attention.
Most investors tend to use a relative value process when considering any investment that will incorporate macroeconomic technical and fundamental analysis (top down), together with sector and individual security analysis (bottom up).
Many investment processes look to generate excess returns by considering a number of selection criteria or alpha: usually global market sector, issuer, duration, volatility, market timing – entry levels are as important as the analysis behind the purchase – and risk and return.
Investors with a passive investment strategy will look to own the alpha process at the top level, but will delegate the active management of this alpha by investing in a fund or ETF.
In the bond universe, investors can consider the sovereign bond market. This would include conventional and index-linked debt, together with corporate bonds – both investment grade and high yield – and emerging market issuers in order to gain exposure to their preferred sector without being overly burdened with idiosyncratic analysis.
| Fixed income ETFs: Expert view |
Stephen Cohen, head of fixed income beta at BlackRock, gives his prediction for the bond ETF market in the third quarter: “The second quarter of this year saw bond exchange-traded funds [ETFs] break through the $600bn [£454bn] barrier in assets. The strongest driver of flows remains the search for yield. We saw a surge in demand for European corporate bond ETFs following the European Central Bank’s March announcement of its corporate bond-purchase programme. There was also an increase in demand for US investment-grade and euro corporate ETFs as European government bond yields moved further into negative territory after the UK voted to leave the EU. “Our prediction for the third quarter is that exposure to US-based corporate bond ETFs among European investors will rise, given government bond yields in the US are not as suppressed as they are in Europe. We also expect investors will pay more attention to their currency exposure in light of recent volatility in currency markets. With bond ETFs increasingly used as a financial instrument within portfolios to transfer risk quickly and as investors are asking for more granular exposures, we expect to see even more innovation in the industry throughout the third quarter.” |
Optically, bonds appear expensive but they do offer a regular coupon, whereas equity dividends are always discretionary and offer an alternative to cash.
Corporate and high-yield debt are currently a more dynamic investment, while sovereign debt can capture any outperformance in duration and add a certain defensive tilt to the investment process.
Possibly the easiest way for the retail investor to gain exposure to fixed income is to utilise the ETF market, especially in the high-yield space.
ETFs have provided investors with easy access to the high-yield market, with assets under management growing from zero in 2007 to $51bn (£38.6bn) by mid-May 2016.
Globally, fixed income ETFs gathered $43.8bn in the first quarter of 2016 and $91.7bn in assets last year, with corporate bond ETFs the biggest driver of growth and increasing trading volumes, despite lacklustre growth in over-the-counter bond liquidity.
However, fixed income ETFs are still a fraction of the underlying bond markets. High-yield ETFs make up just 2.6 per cent of high-yield debt, with investment-grade ETFs comprising just 1.3 per cent of the investment-grade market.
With regard to global government bond markets, fundamentally weighted ETFs offer an alternative approach to traditional market-cap investing, which overweights those issuers with the greatest level of outstanding debt.
This approach aims to better diversify portfolio risk, as well as improve the risk-adjusted returns.
As it stands, dealing spreads on ETFs have held up relatively well and remain quite tight.
With regard to liquidity, especially in the high-yield space, ETFs can never be more liquid than the underlying market they track. Hence liquidity issues would be an asset class problem and would affect all investors, no matter which investment vehicle they have used.
Lynn Hutchinson is assistant director and Jeremy Spain is a fund manager at Charles Stanley
