Could ETFs enhance a fixed income allocation?

Data from ETFGI on European exchange traded funds for the end of August shows, of the total 3,333 ETFs, 567 were exposed to fixed income, compared with the 1,528 with equity exposure.

Deborah Fuhr runs ETFGI and has been doing research on the sector since 1997. She says: “For the first 10 years [of ETFs] it was all equities; it wasn’t contemplated initially that ETFs would be covering fixed income or other asset classes, and then it moved to fixed income and we have seen significant growth. 

“The first fixed income ETF, launched in Canada, is turning 25 in November this year.”

And Finn Houlihan, managing director of AAF Financial, says ETFs are a good way to bring down costs for clients while capturing the benefits of fixed income. 

Read the full guide to ETFs here

He notes fixed income markets are “alive and kicking again” after a “lost decade of interest rates”. 

“If I’m sitting as a financial planner and I’m thinking about the total cost for the client then making it up of ETFs is brilliant, because it’s bringing the total cost down you know, when you factor in platform cost, fund costs and advice,” Houlihan adds. 

Fixed income ETFs can be used as a low-cost way to build diversified exposure to the bond market, without having to tackle individual bond purchases or mutual funds.

David Batchelor, senior fund analyst at Quoted Data, says ETFs can offer advantages over the alternatives of gaining exposure to bonds. 

“They offer intraday liquidity and diversified exposure, and access to an asset class that can be difficult to access directly for many investors, not least due to high minimum investment levels for individual issues. 

“ETFs offer an easy way to fine-tune duration and credit exposure at low cost, with fees typically being much lower than for actively managed funds.” 

Batchelor says the ability to get real-time prices for ETFs provides more efficiency in the fixed income market, compared with the over-the-counter quotes that were previously relied on. However, there are some areas in fixed income where ETF benefits are limited.

He adds: “There are limits to what ETFs can offer though, and in particular they generally only invest in liquid underlying bonds, in order to ensure liquidity at the fund level.

“If investors want exposure to less liquid bonds, which tend to be higher yielding and issued by smaller companies, there are specialist investment trusts available that take advantage of their own permanent capital structure.” 

Weixu Yan, head of passives at TrinityBridge, says the ETF structure is “particularly well suited” to the fixed income asset class.

“Unlike mutual funds, where trades occur directly between the fund provider and the investor, ETFs also trade on secondary markets such as exchanges or through stock brokers. 

“This means transactions often occur between two investors, without requiring the fund manager to buy or sell the underlying fixed income assets each time. As a result, trading costs are reduced, especially in less liquid segments of the fixed income market.

“On top of the secondary market access, the ETF structure also features an in-specie creation and redemption mechanism, which allows providers and investors to gain access to bond issues that might otherwise be difficult to access.” 

When it comes to active management in the ETF fixed income space, fund managers can improve yield by being overweight on bonds with favourable credit outlooks. As well as changing an ETFs yield, managers can alter its risk profile. 

Terry McGivern, senior research analyst at AJ Bell, says: “Fixed income is definitely a more ripe area for active ETFs than equities, because I just think the equity markets are so efficient and so difficult to beat. “In the bond markets, I think there are areas where thinking like an active fixed income manager probably would be fruitful.” 

While active managers are constantly competing against an index comprised of the largest companies in a particular market, a bond index is comprised of the most indebted companies in a market, with the consequence that an active manager of an ETF has greater scope to deviate from an index, and potentially beat it.

This article is part of the Special Report on ETFs.

Click here to read the next article in the Special Report

Tara O’Connor is a senior reporter at FT Adviser