If one of the purposes of exchange-traded funds is to provide liquidity for an underlying asset class, then it may seem that fixed income is one area where they might find it difficult to gain traction, as most parts of the bond market are inherently liquid.
Myles Bradshaw, head of global aggregate bonds – fixed income group at JPMorgan Asset Management, says another feature of the bond market is that most of the assets are held in active strategies – less than 2 per cent is in passive instruments.
He says the main reason bonds tend to be held within actively managed strategies is that indices are not particularly built with investors in mind, because the companies that comprise the biggest part of the index are those that have the highest level of outstanding debt, and so may be the lower quality company.
Bradshaw adds that the global aggregate bond index is so broad that passive providers cannot, for reasons of complexity and cost, include every single bond that is part of the index, meaning that investors who prefer passive solutions are unable to access the entire index.
There are around 30 active ETF products in the fixed income universe.
On the reason why the ETF structure is suitable for fixed income investing, he says: “Fixed income delivered through an ETF vehicle can give bonds equity-like characteristics and allow for instant diversification and portfolio convenience.
"Building bond portfolios is often difficult, and it can take months to source and trade desired bonds in the market. The trading efficiency of ETFs can solve many of these challenges for investors, creating an experience like trading a single equity security at current market price.”
Bryan Armour, director of passive strategy research for North America at Morningstar, says the active ETFs presently on the market in Europe tend to own substantial parts of the relevant index, and therefore investors should not, in his view, expect returns to be delivered that are greatly beyond those that would be achieved via a relevant tracker fund.
Morningstar research shows that much of the growth in the active ETF fund universe in recent years has come from increased demand for fixed income strategies, particularly during the period when interest rates were low, but Morningstar notes active ETF equity strategies have gained popularity more recently.
Morningstar says demand for active fixed income ETFs has “see sawed” in recent years alongside the fate of the bond market, with investors more recently switching their allocation to longer dated bonds.
Longer dated bonds tend to perform better when market participants are more concerned about the outlook for economic growth than they are about inflation.
In such a scenario, the expectation is that central banks would cut interest rates to stimulate economic growth. Rates being cut would lead to lower bond yields on new government debt coming to market, increasing the desire of investors to lock in the yields on bonds already in the market for as long as possible, pushing up the prices of long-dated bonds.
In contrast, when investors anticipate much higher inflation, they wish to own bonds with a much shorter maturity, as they anticipate central banks will increase rates in order to combat inflation.
Owning shorter duration bonds in such a climate may offer investors protection against the risk of higher rates, as they will have matured before the full impact of changes to the base rate are felt on bond prices.
Additionally, if investors are faced with higher inflation, then it may be the case they require a higher income yield from their portfolio, in which case they may seek to own bonds that carry a greater level of credit risk, such as high-yield bonds, and those tend to be shorter duration in nature relative relative to government bonds.
Commenting on how JPMorgan seek to actively manage the fixed income ETFs they run, Bradshaw says: "We use research across economic indicators, fundamental factors like spreads or relative value as well as technical factors like new issuance or trading volume.
"Based on this, we make active investment decisions across sectors, securities, duration/yield curve management as well as currency and hedging."
The spread is the extra yield one gets on one bond relative to another, usually on a bond with additional credit risk relative to that of a government bond, or extra duration risk relative to an index.
This latter is known as the term premium. The supply and demand dynamics of the bond market have been impacted by central bank bond-buying programmes, known as quantitative easing, and by the subsequent withdrawal and reversal of that programme, a policy known as quantitative tightening.
Additionally, the supply of bonds is impacted by the level of issuance made during the era of very low interest rates and the necessity or otherwise for companies to refinance that debt and to issue new bonds.
david.thorpe@ft.com
