By James Waterworth, vice president UK & Ireland institutional sales, Lyxor
The rise of ETFs has been traditionally dominated by the proliferation of equity exposures. More recently however, investors have been turning more and more to bond ETFs. Lyxor data shows that in 2015, fixed income ETFs gathered USD 28.9bn in net new assets, a three-year record high accounting for 35% of all European ETF inflows. As at the end of 2015, fixed income represented a quarter of the ETF market with USD 123.5bn in assets under management.
This growth in fixed income ETFs is perhaps unsurprising given the macro environment: low interest rates have herded investors towards corporate bonds, while more recently market volatility has made traditional safe haven assets such as gilts or treasuries more attractive.
So why have ETFs in particular benefited from this increased interest in fixed income? The hallmarks of an ETF are low cost, transparency, diversification and liquidity. We can look at each of these features in turn, and see how they can be applied to the fixed income space.
Starting with cost, because bond ETFs passively track rules-based indices, management fees are inherently low. This is in contrast to active fixed income managers who charge higher fees to cover the costs of employing teams of research analysts. Lyxor's gilt and treasury ETFs for example have a Total Expense Ratio of just 0.07%, and our Investment Grade Corporate bond ETFs are just 0.09%.
Transparency within fixed income ETFs comes in two forms. Firstly, investors know exactly what they're getting and in what quantity, as the underlying index offers full daily transparency with regards to the constituents and their individual weightings. Secondly, the ETF wrapper brings more transparency around trading costs. While some bonds like govies can be traded on-screen, they are typically traded over-the-counter (OTC) via an interdealer broker. This is particularly true for corporate bonds, and it is an opaque process compared to equities that trade intraday on regulated exchanges. ETFs hence democratise the process: whether investors trade one share or £1m worth, they receive the same terms with regards to liquidity conditions and trading costs.
ETFs offer instant diversification in a single trade. So rather than put together a basket of individual bonds one by one, investors can buy broad exposures to, for instance, UK or European government bonds, or US corporates. They can also be more granular in their views by diversifying across different markets, durations, and credit quality.
As their name indicates, ETFs bring an additional layer of liquidity by virtue of being traded on exchange - what is commonly known as the ‘secondary market'. It is not uncommon to see bond ETFs trading within tighter bid-offer spreads than the weighted average spreads of the underlying bonds trading on the primary market. Furthermore, we saw that in periods of market stress such as in 2008 and 2011, ETF investors benefited from the ability to get in, and crucially, the ability to get out of their fixed income positions. That said, ETFs are not magic wrappers: in a heavily falling market, an ETF will only ever be as liquid as its underlying components. This means that if the liquidity of the underlying bonds deteriorates during a broad sell-off, ETF holders may be affected by the resulting widening bid-offer spread.
Driven by low cost, transparency, instant diversification and secondary liquidity, we expect ETFs to continue to resonate with fixed income investors going forward. Looking at cost in particular, the low return environment we find ourselves in means that fees are increasingly eating into returns, and investors are paying closer attention to Total Expense Ratios as a consequence. This was why we cut the fees on UK and US government bond ETFs to 0.07%, and UK and US investment grade corporate bond ETFs to 0.09%, giving UK investors a better deal. At the time of writing, they are the cheapest ETFs in the European market compared to commonly used competing products.
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