How Investors Are Rethinking Fixed Income ETFs

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Navigating the Covid challenge

BOND ETFs: HOW TO USE THEM

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Rethink Fixed Income with ETFs

How Investors Are Rethinking Fixed Income ETFs

The role of fixed income assets in investor portfolios has shifted significantly in the past decade. Nicholas Mandrinos, Partner at Stonehage Fleming, and Brett Olson, MD and Head of Fixed Income ETFs at BlackRock, discuss how ETFs have supported investors through this change.

Investors have historically allocated to fixed income to meet three key objectives: capital appreciation, income generation and principal preservation. However, years of extremely low interest rates have limited the prospects of future capital appreciation, diminished income generation and questioned fixed income’s diversification benefits. ETFs, however, have supported investors through these changes and are helping all types of investors access bond markets. ETF usage varies from investor to investor, depending on the outcomes they are seeking from their bond allocations, says Nicholas Mandrinos, Partner at Stonehage Fleming Investment Management. “A traditional credit investor is no longer happy with getting returns for investment-grade bonds of, say, 2.5%,” he explains. “They are being forced along the risk curve, they are migrating into high yield, while high-yield investors are moving into private credit, and so on. It’s very different from where we were five years ago, and even more different from where we were 15 years ago.”

Fixed income portfolio construction has evolved in parallel with the fixed income ETF industry growing and maturing. Fixed income ETFs were put to the test in 2020 as pandemic-induced market volatility hit almost every asset class and region. For many investors, using ETFs was a far easier way of trading than using single bonds due to the ability to trade ETF units without touching the underlying securities. While certain fixed income asset classes have been challenged by market conditions in the past, the Covid-19 pandemic was the first event to affect almost all fixed income sectors. “We had the perfect storm, where every fixed income asset class came under pressure,” recalls Brett Olson, Managing Director and Head of Fixed Income ETFs at BlackRock for EMEA. “The [ETF] structure once again proved its resiliency; this volatile period proved once and for all that the structure works well, providing price discovery and liquidity to investors. Since then, the adoption has continued.”

The traditional role of bonds as a yield play or basic diversifier may have been challenged over the past few years, but the emergence of ETFs has given the asset class new potential roles for portfolio builders like Mandrinos. “ETFs are an extremely important building block for portfolios,” he says. “The ETF market has come on in leaps and bounds over the past few years, and there is a plethora of products allowing you to express particular views.” As well as broad global and regional products, investors can access more granular exposure such as high-yield, inflation-linked, sustainability focused or various duration plays. Mandrinos chiefly uses ETFs to “build into exposures quickly.” For instance, he cites the ability to gain exposure to the broad U.S. Treasury bond market, to capture market beta at a low cost without having to access direct securities. Such tactical exposures allow investors to express short-term views, or transition into an asset class swiftly while searching for a longer-term active manager.

As well as low-cost strategic holdings and tactical plays, other uses are emerging, says Olson. Some BlackRock clients are using certain types of bond ETFs as an alternative to cash holdings, he says, using highly liquid, short duration bond funds to produce a higher yield than cash—albeit with more risk—while still giving the holder access to a quick sale if needed. ETFs can also be used in hedging arrangements and in securities lending programs, potentially providing stock lenders with additional income, Olson adds. Crucial to the success of ETFs in their variety of roles is the scale and liquidity of a fund’s units. As Olson explains, investors looking to incorporate fixed income ETFs into their strategies need to be confident that the product and the manager they choose can fulfil the roles they are required to play. The more niche or esoteric a product, the more legwork an asset allocator should do before jumping in, Mandrinos says. “We look at the provider and do background work on operational aspects such as how they handle the underlying assets, and whether it is a market fit to be traded [through ETFs],” he continues. “Investing with a larger provider with an established index business, with extensive knowledge and background in trading underlying securities, gives you more comfort that they can deal with big-volume trades.”

Innovation through ESG

Increasing competition among providers as well as growing demand from investors has led to a great deal of product innovation, and this is set to continue as ETF managers embrace sustainability. The next stage of development in the fixed income ETF market will likely include the expansion of offerings having environmental, social and governance (ESG) themes, agree Mandrinos and Olson. “We’re seeing more and more products come out, whether it’s green bonds, climate bonds or others, that are looking to express particular views on sustainability,” says Mandrinos. Green bonds—fixed income securities that raise money for specific environmental projects or needs—have enjoyed an explosion of interest in the past few years. As of November 2021, green bonds issued worldwide have raised almost $1.5 trillion, according to the Climate Bonds Initiative[4], while similar securities such as social bonds are also attracting interest as more investors seek to make a measurable impact with their allocations. “That’s going to be a key area of development simply because there are incredible amounts of investor flows coming into that market,” Mandrinos says. “For providers, it makes sense to spend a bit of intellectual capital in those areas.” In addition, as products grow and become more liquid, and the underlying asset class develops, ESG bond ETFs could become regular portfolio building blocks, and Olson says that it’s just a matter of time before ESG products are used for liquidity sleeves or hedging strategies. As the sector continues to mature and grow, more innovation is set to bring even more opportunities and choice to investors in the rapidly changing world of fixed income.

Sources: [1] Interim Financial Stability Report, Bank of England Financial Policy Committee report, May 2020 (page 13). [2] “A turning point for fixed income ETFs,” BlackRock report, July 2020. [3] iShares Global Business Intelligence. 3 December 2021. [4] Climate Bonds Initiative website.

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Nicholas Mandrinos, Partner – Investment Management, Stonehage Fleming

“Investing with a larger provider with an established index business gives you more comfort that they can deal with big-volume trades”

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VISIT

This was reflected in a Bank of England report from May 2020, which explained that ETF trading volumes rose rapidly in March and April 2020 as investors sought liquidity. “For the largest ETFs referencing U.S. investment-grade corporate bonds, daily trading volumes in March 2020 were more than three times their January 2020 average,” the BoE report stated. “In light of the relative liquidity in ETF shares compared to the corporate bond market, price discovery was often occurring via ETFs rather than their underlying assets.”[1] This success has meant investor appetite for fixed income ETFs continues to grow. Total assets under management in fixed income ETFs globally is now over $1.7 trillion as of November 2021, according to BlackRock, with a prediction of crossing $2 trillion by 2024.[2] The industry experienced net inflows of more than $251 billion as at 3 December, data from ETFGI show.[3]

BRETT OLSON, EMEA Head of iShares Fixed Income, BlackRock

“This volatile period proved once and for all that the structure works well, providing price discovery and liquidity to investors”

Nicholas Mandrinos, Partner – Investment Management, Stonehage Fleming

“We’re seeing more and more products come out, whether it’s green bonds, climate bonds or others, that are looking to express particular views on sustainability”

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