Fixed income ETFs only account for 2.0% of the total investable fixed income universe globally.1 It is a young market, but has seen robust growth in more recent years.
Adopted long after their equity-based counterparts, there remain a number of myths around the liquidity, risk levels and trading challenges of these funds. We seek to shatter these myths and explain the fixed income ETF structure.
The eight most common misconceptions associated with fixed income ETFs, including their impact on the overall bond market, performance compared to active managers (for mainstream and niche exposures) and implicit overweight to the most indebted companies.
Fiction #1: The fixed income ETF market has become so large it distorts the bond market.
Despite their rapid growth, fixed income ETFs still only represent 2.0% of the total investable fixed income universe globally.1 Flows have been strong but they have not occurred solely at the expense of other types of existing investment vehicles - they have grown the overall market. Because these instruments still represent a relatively small portion of sub -asset classes within the fixed income market, their impact on market prices is limited.
Fiction #2: Fixed income ETFs are not sufficiently liquid, and investors can run into trouble when many try to redeem at the same time
The unique structure of a fixed income ETF — which packages a diversified portfolio of bonds into a single, tradeable equity — provides two sources of liquidity for investors. These two sources – ‘primary’, which can be accessed via an authorised participant and ‘secondary’, which can be accessed directly – define a fund’s overall liquidity profile.
The ability to invest in an ETF via the primary and/or the secondary market can provide greater liquidity compared with alternative approaches to bond investing, such as index and actively managed mutual funds.
Fiction #3: When using a fixed income ETF, the investor is overweight the most indebted — and therefore the riskiest — companies
Large issuers of debt are companies with substantial asset bases and revenue profiles. This provides the ability to pay and service the debt on the firm’s balance sheet. Focusing only on the amount of debt an issuer has in an index overlooks a few key variables.
Indices are rules based, focusing on diversification and liquidity for ensuring investability. As a result, not all of an issuer’s debt is included in an index, which paints an incomplete picture of the firm’s overall indebtedness. For instance, an issuer can have short-term liabilities that do not qualify it for inclusion in an index, or debt financing secured in subordinated form, or financing denominated in a different currency
Additionally, an ETF's index construction inherently provides diversification benefits and often employs constituent capping to mitigate concentration risks.
Fiction #4: Fixed income ETFs underperform active managers when markets are volatile
We analysed seven significant market events over the last 20 years, including the Global Financial Crisis and the COVID-19 pandemic, which represented periods of volatility in the bond markets. The analysis focused on the performance of active managers within the Bloomberg Barclays Euro Aggregate Bond Total Return Index.
Our findings revealed that index-based fixed income exposures would actually have outperformed, on average, 73% of active managers.2
Fiction #5: Fixed income ETFs are only useful for the largest, most straightforward bond exposures, while for niche areas, active managers provide a better return
In the past, investors believed an active approach served as the best way to invest in niche areas such as emerging market debt. That belief has been based on a few assumptions, for example that indexed exposure is too expensive to be effectively implemented in emerging markets, and that emerging markets are inefficient – hence active managers are needed to identify and extract value.
The reality is different. Emerging market debt now offers much greater liquidity and diversity, and our analysis suggests the majority of active managers fail to outperform their benchmarks over the longer term.
While active managers have struggled to consistently deliver excess returns, indexed strategies have evolved and now possess sophisticated techniques capable of delivering the return of the benchmark in a cost-efficient3 manner. Further, an ETF’s diversification can help to mitigate political and sentiment-driven events, which are difficult to predict.
Fiction #6: Index investing doesn’t work for bonds because there are too many bonds to index efficiently
Given the sheer number of bonds, it is generally not possible to hold every single one in an index. For example, the Bloomberg Barclays Euro Aggregate Index contains 5,714 different bonds.4
But an index investment manager’s objective is not to hold every bond in the index – it is to seek to track an index’s return with minimal tracking error. This means replicating the duration, curve and issuer credit exposure of the index in a smaller sample.
Fiction #7: Many investors are not set up to trade fixed income ETFs — the process is difficult, and understanding ETF pricing and liquidity is challenging
Investors seeking to trade fixed income ETFs have straightforward ways to access fixed income ETFs: via an exchange or via over-the-counter (OTC). When considering which one to select, investors should primarily consider their trade size. As with single stock equities, larger trade sizes exceeding average daily volume should be handled with greater care and investors should work with a broker dealer or market maker OTC.
Fiction #8: During the recent COVID-19 crisis, fixed income ETFs exaggerated the decline in the underlying bond market.
Far from driving market weakness, the surge in fixed income ETF trading volumes in March 2020, during a period of steep discounts, suggests that market participants gravitated towards ETFs as price discovery and liquidity vehicles.
3 Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs.
4 Source: Bloomberg Finance L.P., as of 30 April 2020.
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The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All information is from SSGA unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
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Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates rise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
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