Innovation is a key theme in the history of the exchange-traded fund (ETF)1 market and the increasing popularity of bond ETFs are a continuation of this trend. The first US Fixed Income ETF was launched in 2002 and since then assets in the category have grown to approximately $750 billion through June 2019. The asset class has attracted over $65 billion at the midpoint of 2019, representing almost two-thirds of US ETF flows.2
A Fixed Evolution
The rapid growth of fixed income ETFs can be attributed to several factors that apply to the ETF market in general and the fixed income market specifically. First, amid the changing advisory landscape and the shift to fee-based models, ETFs are continually being used to gain liquid3 and transparent exposure to asset classes, including the bond market. Inflows into ETF investment vehicles are evidence of a shift in investor preferences to products with greater transparency, efficiency, and accessibility.
Economy and Scale
As investors discover new, unique ways to use ETFs, one of the major attractions is the potential scalability of bond ETFs relative to managing individual bond portfolios. Fixed income is yet another asset class in the global capital markets that ETFs have democratized, as investors can buy a diversified basket of bonds in a single publicly traded ticker. Also, with scale often comes efficiency, and that can allow bond ETFs to trade even cheaper than the costs of their underlying holdings, just like equity ETFs. This phenomenon is even more pronounced with fixed income ETFs as most fixed income instruments have much larger bid/ask spreads4 compared to equities listed on exchanges.
Regulation and Efficiency
Regulation has also been a key driver in the mass adoption of ETFs as investment tools. In the fixed income space, many bond dealers have continued to shrink their inventory since the Great Financial Crisis of 2007-2008 and are less likely to take on the risk of facilitating large bond trades. This makes the use of individual bonds more difficult. Fixed income ETFs have brought the traditional over-the-counter dealer bond market—and its opaque pricing—to the electronic equity market with real-time transparent pricing. As a result, investors have a seemingly better reference price for bonds that are not bought or sold every day. Lastly, the efficiency of the ETF wrapper means that a majority of bond ETF trades are between buyers and sellers of existing ETF shares, so not every ETF trade has an impact on the underlying bonds.
Fixed Income ETFs, Activated
Like equity ETFs, institutions were early adopters of fixed income ETFs. Institutions have used bond ETFs for easier access to transparent liquid exposures or to manage cash flows. As investors continue to take on the role of asset allocation, the need for asset class building blocks has intensified. One example of this fixed income ETF trend has been the growing adoption of short-term bond ETFs. In the recent rising rate environment, many investors allocated to short- and ultra-short duration ETFs to manage competing priorities – limiting duration5 while seeking yield to meet their investment objectives. An active approach has the potential to result in better risk-adjusted returns as experienced managers look for more yield while managing credit risk and sector allocations. Due to these potential advantages, investors have shown an appetite for active ETFs in the fixed income space.
A Continuing Education
The growth of fixed income ETFs represents an opportunity and a challenge for both issuers and investors. Increasing sophistication in bond trading allows for greater product innovation. Yet, greater levels of investing in less liquid sectors of the bond market need to be carefully understood by all. We encourage investors to understand how their investments will react in normal and, especially, in stressed market environments. Although ETFs do provide supplemental liquidity with secondary market trading, the products are not magical, and the underlying holdings in a sector or asset class is always the ultimate source of liquidity. As a result, ETFs are not immune to bouts of illiquidity in the securities they track or own.
3 The term liquidity refers to the ability to convert an asset into cash quickly, with minimal impact on the price received.
4 A spread is the difference between the bid and the ask price of a security or asset.
5 Duration risk measures a bond's price sensitivity to interest rate changes. Bond funds and individual bonds with a longer duration (a measure of the expected life of a security) tend to be more sensitive to changes in interest rates, usually making them more volatile than securities with shorter durations.
Exchange-Traded Funds (ETFs) trade like stocks, are subject to investment risk, and will fluctuate in market value. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than the ETF's net asset value. Transactions in shares of ETFs will result in brokerage commissions, which will reduce returns. Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity. Volatility management techniques may result in periods of loss and underperformance, may limit the Fund's ability to participate in rising markets, and may increase transaction costs. Liquidity risk exists when particular investments are difficult to purchase or sell, possibly preventing the sale of these illiquid securities at an advantageous price or time. A lack of liquidity also may cause the value of investments to decline. Interest rate risk is a major risk to all bondholders. As rates rise, existing bonds that offer a lower rate of return decline in value because newly issued bonds that pay higher rates are more attractive to investors.
Investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.
Unlike typical exchange-traded funds, there are no indexes that an active ETF attempts to track or replicate. Thus, the ability of an active ETF to achieve its objectives will depend on the effectiveness of the portfolio manager. Transactions in shares of ETFs will result in brokerage commissions, which will reduce returns.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.