Industry Voice: Fixed income ETFs have seen more than €8bn inflows so far in 2018 - one of the fastest growing segments. Lyxor ETF looks at why wealth managers are turning to low cost bond funds.
Equity rather than bond investors tend to make the most use of passive investment products. But over the past few years that's started to change, as the number of fixed income Exchange Traded Funds (ETFs) has grown.
It's understandable why asset flows into fixed income investments lagged their equity counterparts in recent years: as yields are low. As a result, investors are very aware of the impact of fees on their potential returns.
But fixed income ETFs are one of the fastest growing segments of the European ETF market - accounting for almost £1 in every £4 invested in ETFs. Bond ETFs are now looking like serious challengers to traditional actively managed funds.
Low fees for low risk
Within fixed income ETFs, government bonds represent the largest segment. Products which give access to gilts and treasuries are particularly appealing to investors with low risk portfolios. An allocation to this asset class is vital to this style of investment yet actively managed funds struggle to add value despite charging higher fees.
That's why a low cost sovereign bond ETF has been such a useful tool for cautious investors: they can maintain their risk profile while still gaining returns net of fees, even if the yield is low.
Diversifying your bonds
But ETFs are not just the staples - it's now also possible for investors to use passive products to gain exposure to the credit markets, particularly high yield bonds. This expands the investment universe for smaller investors - it was difficult in the past for them to access this market.
And there are advantages to selecting a high yield ETF rather than an active fund. Investing in a high yield bond index tracker can reduce risk as it is more diversified; ETF portfolios may be much broader than those run by an traditional manager.
Credit rating rules are also often more defined for an index than for an actively managed fund. Some active managers might buy a bond and stick with it even if the credit rating of the issuer falls. But an index must always be within the assigned credit quality.
Rising interest rates have made high yield markets more appealing to investors because the duration of these bonds is lower. That means the price of the instruments is less negatively impacted by increases in the cost borrowing than longer dated bonds.
But while low cost fixed income ETFs are opening up markets for investors, there have been concerns about using these types of products. For example, some have queried market weighted corporate indices, where more is held of highly indebted companies.
But these concerns may be overblown. The bond market is materially different to the equity market. This is an over-the-counter market so the trading is carried out by two professionals who look at market specifics. Bonds are credit scored, which means the ability of the company to repay their debt has been assessed. This is very different to equity markets, where a large portion of many companies' shares are still held directly by individuals.
Finding low cost bonds
Low cost fixed income ETFs gives wealth managers a greater range of tools they can use to help their clients reach their investment goals. Whether it's a way for their more cautious investors to access the sovereign bond market or providing those with a greater risk tolerance access to the high yield market, these passive products could prove invaluable.
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* Source for ETF flows and charges: Lyxor ETF, Bloomberg correct as at end September 2018
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