These are heady times for fixed-income ETFs.
Investors put $34.5 billion into these exchange-traded funds in the first quarter, a record for the first three months, according to State Street Global Advisors. Analysts suggest that if this pace of investment continues, assets in fixed-income ETFs could reach $1 trillion by the end of this year.
Investors like the funds as a low-cost product for investing in the bond market. Fixed-income ETFs work like bond mutual funds but offer greater tax efficiency because there rarely are capital gains, and they provide a real-time view into their underlying holdings—something mutual funds don’t offer. Fixed-income ETFs also appeal to investors looking for low-cost options that can increase a portfolio’s strategic capabilities.
Adoption on the rise
“Investors really have a lot of choices—more than they’ve had in the past five years,” says Noel Archard, global head of product for State Street Global Advisors SPDR ETFs. “You can invest all along the yield curve—Treasurys, corporates, high yield,” says Mr. Archard. “We’re also seeing growth in active strategies and factor-based strategies.” Factor-based fixed-income ETFs are a new subcategory that is designed to help investors capture greater yield from broad moves in the bond market.
Mr. Archard notes that investors can now make both tactical and longer-term strategic fixed-income allocations through ETFs. Asset-flow data suggests that investors are doing both. The second half of last year saw significant inflows into ultrashort and short-duration bond ETFs as investors sought to manage duration risk as interest rates rose. State Street offers ultrashort bond exposure through the SPDR SSGA Ultra Short Term Bond ETF (ULST) and its SPDR Portfolio Short Term Treasury ETF (SPTS).
In the first quarter of this year, as earnings season got off to a positive start and the Federal Reserve indicated it would hold off raising interest rates for the near term, asset flows returned to parts of the market that had been out of favor, including high-yield and longer-duration bond funds.
Fixed-income ETFs may also be adding efficiency to the bond market. Ed Lopez, head of ETFs at VanEck, says that fixed-income ETFs have become a mechanism for price discovery in the bond market. Because ETFs have to quote intraday prices, fixed-income ETFs can provide a sense for the overall price range of the bond market. “Investors have more of a real-time view of the bond market through ETFs,” Mr. Lopez says.
Some big new investors are entering the area. Last year, new accounting guidance from the National Association of Insurance Commissioners went into effect, making it possible for insurance companies—some of the largest investors in the bond market—to use fixed-income ETFs in their portfolios. The change is a boon for investors, who could see costs go down for investment products that are managed by insurance companies, like annuities.
Fixed-income ETFs also are making their way into strategies for investors in or near retirement. Jon Rather, a vice president within BlackRock’s Global Fixed Income Group, says the group has seen an uptick in the use of iBonds ETFs, which are a suite of bond funds with similar maturity dates. Investors can use these to create bond ladders, a strategy which is designed to generate a regular income payout during retirement. With ETFs, investors can create a laddered portfolio without having to research and hold individual bonds.
Not everyone is a fan of fixed-income ETFs, however. Daryl Deke, chief executive of New Market Wealth Management, says that for investors with taxable accounts, it can be useful to hold individual bonds; the bonds can be sold for a loss in the current rising-rate environment to offset capital gains from an equities portfolio. Investors should consider the tax implications of changing their fixed-income allocations before making any significant moves.
Mr. Deke also raises concerns about illiquidity in the bond market and how that might be exacerbated by ETFs.
“When people want to exit the market, they tend to want to exit at the same time, regardless of what type of vehicle they are in,” he says. “As the size of these funds grows, we’re concerned about what happens in a major selloff.”
Supporters of ETFs argue that the exchange-traded structure adds an extra layer of liquidity, in part because of the transparency embedded in ETFs. ETF providers are also working on ways to ensure the liquidity of the underlying bonds in a fund. MarketAxess, a provider of indexes used to help build ETFs, recently launched a slate of fixed-income indexes that focus on choosing the most liquid bonds. These indexes are designed to add an extra layer of liquidity to fixed-income ETFs.
Some ETF providers, meanwhile, argue that it’s unlikely for investors who have made long-term bond allocations using ETFs to rush for the exits all at once. Many such investors may increase their positions if stocks enter a correction.
“I think the liquidity concerns surrounding fixed-income ETFs are overblown,” says Rich Powers, head of ETF product management at Vanguard. Mr. Powers argues that for advisers and investors, fixed-income ETFs play the same role in a portfolio as stock ETFs—a low-cost means of maintaining core portfolio holdings. Mr. Powers echoes Mr. Archard in saying that more of the current focus on fixed-income ETFs is on how to build portfolios that solve for particular investment goals.
Says Mr. Powers, “Fixed-income ETFs have been tested more than once over the past 10-11 years, without any major issues.”
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