Fixed-income exchange-traded funds are late bloomers compared with their equities-based cousins. But their popularity has surged in recent years—with funds focused on shorter-duration bonds drawing interest lately—as investors look to marry the benefits of fixed income with the advantages of an ETF.
According to an October report from BlackRock Inc., assets under management in bond-focused ETFs have grown 25% annually for the past five years and are likely to reach $1.5 trillion by 2022. As of mid-February, there was $780 billion in these products, representing 15% of the total ETF market, according to BlackRock's iShares division, the biggest U.S. ETF firm by assets.
While fixed income's share of the ETF market remains small, bond ETFs have emerged as a lucrative niche on Wall Street by promising buyers the steady income of bonds in a package that is as easy to trade as stocks. Bond ETFs attracted $138 billion in new assets in 2017, up from $112 billion in 2016, according to ETFdb.com analyst Neelarjo Rakshit, who says a number of factors are driving the growth.
For starters, he says, an overall boom in passive-investing strategies means there are simply more options available for ETF investors who want to diversify their portfolios with corporate and government bonds. Additionally, while fixed-income ETFs usually pay regular interest payments like bonds, they also offer the benefits of an ETF, such as intraday trading, liquidity, transparency and a relatively low cost compared with mutual funds.
Individual investors have grown more comfortable with fixed-income ETFs, says Kathy Jones, senior vice president and chief fixed-income strategist at the Schwab Center for Financial Research. Schwab says assets under management in the U.S. fixed-income ETFs on its brokerage platform rose to $64.1 billion in 2017 from $49.4 billion the year before. Schwab saw inflows of $12.6 billion into the fixed-income funds over the course of 2017, just over a quarter of the total flows into ETFs.
Most of the money flowing into these products now is going into ETFs focused on shorter-duration bonds, Ms. Jones says, a trend noted by other ETF providers. That is due to interest-rate increases by the Federal Reserve and the expectation of more to come this year, she says. Rising interest rates have a negative impact on the price of existing bonds, particularly those with a longer duration. By buying shorter-term funds, investors can stay invested in fixed income, but mitigate some of the impact of rising rates, she notes.
Why ETFs are dominating
BlackRock's iShares division has seen a change in investor interest over the past year, too, says Heather Brownlie, a managing director at BlackRock and global co-head of fixed-income at iShares.
Eye on rates
"I think people are very aware of the potential for interest rates to move higher, so they're being more tailored about their fixed-income exposure," she says. The $55.18 billion iShares Core US Aggregate Bond ETF (AGG)—which is the largest bond fund in the market by assets and offers investors broad exposure to investment-grade bonds—has negative returns of about 2% year-to-date. Funds focused on shorter-duration bonds, such as iShares 0-5 Year Investment Grade Corporate Bond ETF (SLQD), have fared better, with returns of negative 0.76%.
Buying short-duration bonds isn't the only way fund investors can hedge their interest-rate risk, Mr. Rakshit says. There also are options such as the Sit Rising Rate ETF (RISE), which looks to profit from rising interest rates by tracking a portfolio of ETF contracts and options on futures on two-, five- and 10-year U.S. Treasury securities. The $39.4 million fund is up about 3.49% year-to-date.
RISE was designed to help investors protect their fixed-income holdings from rising rates, says Bryce Doty, senior vice president at Sit Investment Associates and the fund's portfolio manager. Mr. Doty says that "as expectations for rate increases continue to rise, so do two- and five-year yields, and RISE's share price along with them."
The returns for fixed-income ETFs in general have been muted over the past year, and are likely to remain so in 2018, says Rich Powers, head of ETF product management at Vanguard Group, which runs a number of bond ETFs, such as the $36.72 billion Vanguard Total Bond Market ETF (BND), down 2.26% year-to-date, and the $24.58 billion Vanguard Short-Term Bond ETF (BSV), down 0.77%. However, fixed income remains an important diversifier, he says, particularly during downturns in the equity markets.
"What happens in the near term with interest rates is certainly interesting, but what's more important is how fixed income interacts with equities and other assets in your portfolio to help you achieve your goals," he says. "Fixed income is a great ballast when times are tough."
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