The rise of fixed income ETFs in private portfolios

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Elisa Trovato: Investors have witnessed a slow but sure collapse in bond yields, and the financial crisis supercharged this great bond bull rally, spurring more than 700 central bank interest rate cuts across the world and multi-trillion dollar bond buying programmes. But now the super-easy monetary policy is receding, is the 30-year bond bull market nearing its end?

Séamus Ó Ceallaigh I think we’d have to agree that is the case. We know this extraordinary monetary policy will have to come to an end, hopefully slowly. We will see rates rise and we’re getting ready for this start of this cycle. The goal of fixed income portfolio managers is to make sure we can still generate positive returns by looking for sub asset classes of fixed income that are higher yielding, and can provide some form of cushion against the rise in government bond rates.

Chris Bamford I think certainly this year is going to be a more challenging year. We had a very smooth path for risk assets last year. It was relatively benign on the rate side. This year has started differently. We’ve seen a bit of a sell-off in rates. The US 10 year is approaching 2.8 per cent, the sort of level many market participants predicted would be the peak this year. The yield curve is pricing in roughly three rate hikes. 

To the most extent, the environment for high yield is relatively benign from a default environment, so we expect it to be a coupon-like year. We expect limited returns from more traditional investment-grade and sovereign markets.

Elisa Trovato: There have been crucial signs of inflationary pressures of late, and fears  central banks may hike interest rates too rapidly to fight inflation. Is the steady climb higher in US bond yields of late the most obvious sign of the market’s unease with the inflation outlook?

Ben Seager-Scott Absolutely yes. The majority of the rate rises we have seen so far this year have been driven primarily by inflation expectations. Over the last two years, inflation has been conspicuously absent. There is every reason to think inflation should come through from wage pressure inflation, but it simply hasn’t manifested. Some of those tentative signs are coming through and that’s being partly reflected in what we are seeing in nominal bond yields. 

I think the biggest worry in the markets is that central banks have spent the best part of a decade distorting them with extremely loose monetary policy and when that’s withdrawn no one knows what’s going to happen. There is a risk that you can have a period as we have had in the past, with solid economic fundamentals and growth, but the effect of QE and other central bank policies being withdrawn could lead to a correction in what could be quite fragile markets.

Through 2017 we saw quite a lot of ‘dovish hikes’, where hikes come with exceptionally dovish commentary, and yields fall back immediately. I think a lot of it will depend on the central banks’ rhetoric rather than what they actually do.

Chris Bamford We don’t foresee a particularly rapid rise in inflation. Clearly UK inflation is peaking. In the US, there could be a bit of pickup in the wage data in terms of the inflation rate, but we’re not particularly concerned about that. If anything, we think there’s a little bit of a distortion potentially in the data statistics coming out of the US. They’re not fully representing under-utilisation.

Tom Claridge Our core view is that the move we have seen so far won’t become a disorderly move in yields and rises in yields over the next two to three years in the US, and perhaps globally, will be slow and steady. At Julius Baer, we prefer other asset classes, in terms of returns we think are going to be available, but if our clients’ needs can be met investing in high-grade fixed income, we don’t think there’s any reason to be worried about buying duration at this point. 

Elisa Trovato: The market has shown it’s very sensitive to any whiff of the central banks being less aggressive. How do you face volatility in fixed income portfolios?

Lynn Hutchinson We are mainly short duration. Yields are rising but we still need to allocate a fixed income portion to portfolios. We tend to allocate more to corporate and government bonds and not so much in high yield anymore. 

James McManus There is no doubt bond volatility is going to have to increase in a post QE era. Fiscal policy expanding and monetary policy tightening are both bond negative events. Our view is bearish on sovereigns and supportive for credit, given the fundamentals. In 2018, there will be opportunities for managers to be more tactical, particularly on the sovereign side. There will be periods of pullback in yields and yields will rally at certain points. There is still a lot of risk out there from a political perspective and room for disappointment in the economic outlook. 

That said, when you look at the consensus view, fundamentals are strong. The US economy is incredibly strong. Tax cuts have added fuel to the fire. In corporate balance sheets, we are going to see some deleveraging and possibly some buying back of bonds.  

Elisa Trovato: The market share of fixed income ETFs on total ETFs assets has decreased slightly over the past year, to 15.7 per cent, from 16.7 per cent at the end of 2016, globally. Around 90 per cent of private banks have a tactical underweight position to fixed income, according to PWM’s third annual Global Asset Tracker survey. How does the current environment affect your decision to launch new products? Do you expect the proportion of fixed income ETFs to rise in the future?

Edward Malcolm In Europe, the AuM of fixed income ETFs is around 23 per cent, but in 2017 around 26 per cent of flow went to fixed income ETFs. That’s on the back of a very strong equity market. We expect to see continuous fixed income flow this year, but investors are being much more selective, and we see them move to emerging market debt local currency, because of the yield differential versus domestic markets, and convertible bonds, because of their equity-like features. These are our two big calls we’re speaking to clients about now.

Floating rate ETFs was probably the most popular asset class in fixed income ETFs last year and we are seeing lots of flow into TIPS [Treasury Inflation Protected Securities], as people are starting to protect portfolios in case inflation spikes. 

The current market environment isn’t necessarily as favourable to fixed income as in other periods, but we have recently launched the SPDR Barclays Global Aggregate Bond ETF, which is a long-term holding. We see big institutional clients allocating to that benchmark because they’ve got a longer time horizon. At 10 basis points, it’s a long-term, cost effective solution. 

Currency hedging is very important. We’ve seen a lot of currency volatility over the last few years. Generally, fixed income investors tend to hedge their portfolio, but I think more and more are going to demand currency hedged ETFs, especially sterling investors at the moment. 

Elisa Trovato: How do you currently utilise fixed income ETFs in portfolios, and do you expect to make higher use of these passive vehicles in the future? 

Séamus Ó Ceallaigh We use ETFs, especially corporate bond ETFs, as adjusters for our overall duration. If we add a longer dated risk sub asset class like emerging market, hard currency debt, that would bring the duration up of the portfolio, so we might sell some of our longer dated ETFs and buy a shorter dated ETF, because of its liquidity. ETFs are very useful in our portfolio for that.

James McManus We utilise purely ETFs, equity and fixed income, in our portfolios. We believe they are an excellent tool for implementing an asset allocation. They are cost-effective, efficient and transparent. We can understand and model our risk accurately. There are also some underappreciated aspects of ETFs, and particularly fixed income ETFs, when it comes to transparency on costs. When we go to trade, we understand exactly what it is going to cost to acquire that basket of bonds. Particularly in fixed income, the trading cost and the market impact is something that everybody should be aware of.

Segmentation of the bond market is a fantastic initiative in the ETF market. It allows us to be more tactical. There are also lots of other innovations. For smart beta, putting fundamental research into a rules-based approach makes a lot of sense. I think we will see a lot more of those products going forward. The more tools we have for asset allocation, the better. 

Chris Bamford We are not the most active users of fixed income ETFs. We do have an asset allocation range of funds that are purely passive, but in our active multi-asset funds the predominant allocations within fixed income are through active managers. 

We tend to use ETFs for tactical purposes when the trade horizon is short, less than a year. Also, we also tend to use ETFs as a way of hedging cash flows. In discretionary client portfolios, it is still a relatively challenged area for us because we don’t have the proliferation of hedge share classes across the major broad asset classes. That is a stumbling block that prevents us from using ETFs more systematically. 

But in general, we would tend to favour active management for long-term investment. Even in the sovereign space we think there is still scope to outperform through active managers.

However, we think there is room for growth for ETFs and we are talking with providers about expanding the toolkit that will allow us to better utilise their products. There are significant pressures in the industry around costs and from an observable cost, rather than an opportunity cost, allocating to fixed income ETF does have a benefit. 

This is probably less significant than you would see in the difference between going from an active equity fund to a passive equity fund, but there is still a little bit of a pickup. 

Ben Seager-Scott I’m certainly a nightmare for providers, I am sure other people are. As an allocator, I want a toolbox. I would like every region hedged and unhedged, duration controlled and credit controlled. I want all the options and I probably won’t put a lot of assets into most of them. 

Lynn Hutchinson And we want them as cheap as possible. The other good thing is spreads are so narrow on bond ETFs, compared to going and buying the underlying. So, it just makes them more accessible for retail clients. 

We have different types of portfolios, including just purely passive, as well as portfolios with a mixture of passive, active and direct equities and then portfolios that are just purely active.

Particularly for government ETFs, I don’t see much point in paying higher active manager fees, but we use both active and ETFs in corporate fixed income. The smaller the client portfolio, the more we tend to go into passive vehicles. 

With yields going up, TIPS are likely to be a good investment. With China tightening, and money flowing into emerging markets, that might be a good investment too. We’ve seen major flows going into corporate bond ETFs as well.

We tend to use fixed income ETFs in the core part of the portfolios, for the long-term, unless we are investing a small proportion in high yields or emerging market debt. That would be more on a tactical basis. We have seen more client demand for ETFs, but more focused toward equities than fixed income.

Elisa Trovato: Fixed income ETFs were first launched in 2002, approximately 10 years after equity ETFs and remain a small part of the ETF universe. What are the reasons for that? 

Edward Malcolm There is catching up to do. Also, equity ETFs are used by a broader variety of investors. We’re starting to see pure bond managers incorporating bond ETFs into their portfolios, but that’s taken time as historically they viewed them as an equity product. 

The topic of liquidity and fixed income ETFs has resulted in more scrutiny on fixed income ETFs. This is very important but equally there needs to be an understanding that it is the underlying liquidity which is critical, as opposed to the ETF wrapper.

Also, the difference between active and passive wasn’t so great as it was in the equity space, when it came to fees. But that’s changing and hopefully will entice more investors into fixed income ETFs.

Tom Claridge One of the reasons why fixed income ETFs have lagged equities is partly because of the nature of the instrument. ETFs are equities, so the underlying liquidity and the liquidity of the vehicle is similar. With fixed income, you need to be a bit smarter about how you manage them. Also, ETFs originate in the US, which is an equity-owning society. 

Finally, there’s some misconception about the nature of indices within fixed income. It’s true to say that, on an absolute basis you own the most indebted companies, but on a relative basis it’s not necessarily the case. If I buy the US corporate bond index for an ETF, two of my top 10 holdings are going to be Microsoft and Apple. So, you end up owning the biggest companies, just as much as anything else. 

And on the sovereign side, you’ve got the Japans and the Italys with large debt levels but, actually, you end up owning the biggest countries as well. There is some relationship between the relative amount of debt, of course, but it’s the size of the economies and the size of the companies which matters more.

Elisa Trovato: What are the main stumbling blocks when it comes to further segmenting the bond market through ETFs?

Chris Bamford The most important thing for ETF providers is to have a large investor base of diversified clients who have different views and want to trade these instruments actively. That way you tend to get lots of secondary market activity without having to go to the primary underlying vehicle. The more you segment, the more you diversify, the more you create choice for people. But you need to have enough participants willing to take both sides of the trades for those instruments to flourish, to have the capacity in them.

Edward Malcolm At SPDR we’ve carved up the Barclays Global Aggregate Bond Index into different duration and currency buckets. The challenge for us in launching a product is to ensure that it is scalable and can remain liquid in all market environments. If you carve it up too much, then there may not be enough liquidity to launch an ETF. 

For example, in the sterling corporate bond market, we can’t carve that up too much because it’s not the most liquid market, where as in the US we can be more granular with our ETFs.

Elisa Trovato: Will product innovation contribute to drive growth in fixed income ETFs? 

James McManus  I’m not sure that product innovation, right now, is what needs to drive growth in fixed income ETFs. I think it’s an appreciation of what the products can bring to a portfolio management process, more than anything. An appreciation for investors as to how the market really works, why spreads can be tighter on high yields ETFs than on the underlying bonds, on the basis that if you sell high yield bonds through an ETF structure, you don’t necessarily touch the underlying bond market. Those units of the fund can stay warehoused, they may be passed to another market participant, and that means your actual cost of market impact is significantly lower.

Tom Claridge What will drive growth in fixed income ETFs are cost, and not just TER, but cost of entrance, cost of exit, so bid-offer spreads and tracking error. These are all the things we look at. Also, we use ETFs for liquidity transformation, as the underlying corporate bonds are less liquid than the wrappers. ETFs are becoming liquid as more people are investing in them; it’s a sort of virtuous circle.

Séamus Ó Ceallaigh Where innovation has come is in the index provision. ETF providers are going to index providers and saying ‘build me an index that does this, what the client wants’. And providers have been speaking to us and other managers, finding out what we want and putting together that product matching the ETF. 

Looking at what indices we use, for example, for emerging market local debt, we’ve all used a gross index which ignores unavoidable taxes, which doesn’t take into account the tax levels. But yet, for years in the equity space we’ve used MSCI World total return net which includes taxes. We should change our benchmarks accordingly. It’s how the industry, especially in fixed income, is developing over time.

Edward Malcolm The development of indices in fixed income will help the growth of fixed income ETFs. Six years ago, there wasn’t really a big emerging market bond ETF in Europe and that was our top selling ETF in 2017. Over the last five years, active managers in the emerging market local currency space have struggled, so we’ve seen a big shift of investors moving from active to passive in that asset class, and that will see growth.  

It has been only in the last two years that we’ve launched the first global convertible bond ETF, which has been very popular over the last 12 months but shows how much innovation is still possible in fixed income ETFs. 

Ben Seager-Scott I think the biggest growth factor has nothing to do with providers or us. It’s the market, and you need a correction in the market for investors to think that lots of different parts of the fixed income market are attractive and start piling in. Until you get there, people are just holding off from the whole market. 

There is an element of investor and journalist education as well around how ETFs work. When there have been shocks, some journalists have talked about big discounts, not understanding the difference between a reported NAV and indicative NAV. So it’s how it’s going to be reported as well, because that will effect sentiment and in turn it will affect the market.

Chris Bamford I think if we saw a big aggressive sell-off in fixed income, that would help people’s confidence in ETFs, if ETFs were able to weather that period well. Because one of the debates people have, rightly or wrongly, is ‘we’ve not really seen how these types of vehicles will handle a 2008 type of environment’. The vehicle itself should be able to deal with that, with the bonds taken out of the product. 

But there’s probably a limited understanding of how that process works. Clearly the whole market, whether you’re active or passive, will be impacted by the technical sell-off. So, that scenario, assuming what I’ve said is right, would lead to more confidence in being able to use ETFs.

James McManus Over the last eight years there have been periods where ETFs have been tested, such as taper tantrum, and multiple periods of high yield sell-offs. 

The bond market is not exchange driven, it contains stale bond prices, therefore the price at which you can sell the bond today might not be the price at which it was mark-to-market last night, or last transacted. That impact will be the same whether you hold an active fund, an ETF or the bond itself.

Elisa Trovato: Where can investors still find value in fixed income? Looking ahead, which parts of the fixed income market do you expect will attract the most assets?

Séamus Ó Ceallaigh In terms of fixed income ETF flows, I expect them in emerging market local debt, especially, but also high yield, because of the pretty benign default rate environment, and likewise for credit. The global growth story and more tightening financial conditions should all be good for spreads. Apart from possibly convertible bonds and emerging market local debt, which will be driven by the weak dollar, if it continues, for every other fixed income sub asset class it’s really about carry, this year.

We do use emerging market local debt. It takes a while to find an active manager that you’re happy with, but we are happy with our one. In previous years, we have tactically gone in for maybe four or five weeks, but you can’t really do that with an asset class like this. It’s so expensive, the spreads are so wide, you can’t suddenly buy this ETF and sell it the next day, so we hold fire, find an active manager and then invest that way.

Tom Claridge Because we’re still at the adoption phase within fixed income ETFs, at the rapid growth phase, with 20 plus per cent growth per year, just as last year it will be the larger parts of the market that will attract the most flows, such as investment grade and government debt. On the whole, people are selling active and buying passive, they’ll do that in that sort of pro rata way.  

We like emerging market hard currency, for three reasons. Commodity prices will remain stable, which is significant for emerging market debt. Global growth continues to be impressive and buoyant, and also, we think there’s probably a bit more value in emerging market hard relative to developed market debt, especially when you allow for the different levels of leverage. 

Currently we’re using an active manager we like in that space, but we would certainly use ETFs if we wanted to increase our tactical position, or at different times in the cycle.

Lynn Hutchinson Global inflation, which includes about 50/60 per cent in TIPS and currency hedged, are the segments we expect will attract the most assets in fixed income ETFs. We are invested in global aggregate and predominately in short duration UK corporates, which do have international underlying. 

I see larger inflows going into fixed income this year. As returns are lower, and transparency of cost increases because of regulation, investors will be taking costs into more consideration. KID documents must include transaction costs, and any swap costs as well, which for an active fund and investment trust can be quite significant. Investors don’t mind paying costs while they’re seeing growth, but once the growth reduces they will be taking account of all the costs. Particularly because now their valuations are giving an underlying cost of everything they hold, that will be adding inflows to the ETF market.

In the fixed income space, you can get some really cheap ETFs, for 7-9 basis points. I still think there’s some improvement to be made by some ETFs providers, particularly on fixed income costs, but some of them are cheap to access.

Ben Seager-Scott The big problem is, most of fixed income looks unattractive, just different shades of unattractive. Everyone is trying to get fixed income without getting fixed income, with emerging market debt, or taking advantage of credit. 

We’re doing something similar, using short-dated credit where the pull to par effect limits your broader exposure and you get some sort of return. Until you see sovereign yields move materially higher, those parts of the market are probably going to draw a lot of interest. 

Looking through the course of the whole year, if you see US 10-year Treasuries getting closer to three per cent, that’s the magic number. I think you’ll see a lot of people flowing in there, which probably means it will never quite get there. 

As always happens, it will tick up, but not quite hit that point. But if you do see that happening, as we see QE programmes being withdrawn, a
lot of people will get more interested, and will be buying Treasuries through ETFs.

James McManus We’re talking about what we think flows will be, based on a consensus position, but you don’t go through many years where the consensus position holds. In case of a risk-off event, you are going to see some very different flows to potentially what we’re talking about now. 

For us, that would maybe look like adding some long-dated duration into the portfolio, particularly long-dated Treasuries as protection, somewhere you’re going to get a lot of bang for your buck quite quickly from a duration perspective.