A prolonged low interest rate environment. An ongoing European debt crisis. An impending fiscal cliff. 2012 presented investors with more than their fair share of challenges, and if we look back at the year’s flows, we can see how investors used fixed income ETFs to navigate the tricky environment.
One big priority for investors this year was income, and investment grade corporate bonds proved to be popular for investors who were on the hunt for yield. Through the end of November, investors had allocated more than $16.1 billion to investment grade credit ETFs. We saw credit spreads on investment grade corporate bonds tighten in by 0.88% to 1.46% over Treasuries1 and total returns were +11.8%2 year-to-date through the end of November.
Credit spreads are a measure of the additional amount of yield the market demands for taking on the credit risk of the issuer. When credit spreads decline, the market is anticipating less concern about credit risk, and bond prices on credit risky bonds generally rise. We saw the iShares $ Investment Grade Corporate Bond Fund (LQD), which celebrated its 10-year anniversary in July, overtake the iShares US TIPS ETF (TIP) as the largest fixed income ETF in the world with over $26 billion in assets under management.
Another big beneficiary of hunt for yield — high yield bond ETFs. These ETFs attracted $10.5 billion as investors were willing to take on more credit risk. Credit spreads on high yield bonds declined by 1.53% to 5.46% over Treasuries3 through the end of November.
US Treasury ETFs experience several flight-to-quality events this year. For instance, after the US presidential election, investors favored longer duration Treasury ETFs to hedge against equity market declines ahead of the fiscal cliff. But overall, these funds had net redemptions of $2.3 billion in 2012. With economic growth remaining slow, inflation became less of a concern among investors and TIP had net redemptions of $559 million over the year. But concern about higher tax rates in 2013 prompted investors to add $3.4 billion to municipal bonds ETFs.
This past year, we observed many investors looking to diversify out of US and developed market investments. To do so, they turned to emerging market debt ETFs. These funds offered compelling yields and less volatility than emerging market equities4. US dollar-denominated EM funds attracted more than $3.6 billion, while local currency (+$1.3 billion) and EM high yield (+$164 million) also gathered assets.
Another trend we observed this year was an increase in liquidity for various segments of the fixed income ETF market. Looking at fixed income ETFs with assets over $1 billion, we can see in this chart below the increase in exchange traded volume as more investors began using the funds.
The total assets in high yield ETFs increase by 58% throughout the year, and market trading volumes increased by 92% year-over-year. Notice that during May and November high yield volumes spiked. These increases in volume accompanied periods of high yield redemptions. Getting into an investment is just as important as getting out, and liquidity increased during these periods of redemptions. Emerging market debt and investment grade corporate bond fund volume also greatly increased as the demand picked up in both areas.
Overall, 2012 was a year in which investors tapped into the full array of fixed income ETFs to execute their investment views – be it the hunt for yield, a desire for diversification or as a shelter from rising tax rates. In 2013 we expect investors will be focused on implications of taxes, adding yield and looking for ways to enhance liquidity. All of these trends point to the increased use of fixed income ETFs.
Karen Schenone is a fixed income strategist at BlackRock Financial Management.
1: As measured by the change in option adjusted spread from 12/31/2011 to 11/30/2012 on the Barclays US Corporate Bond Index
2: As measured by the total returns on the Markit iBoxx $ Investment Grade Corporate Bond Index from 12/31/2011 to 11/30/2012
3: As measured by the change in option adjusted spread from 12/31/2011 to 11/30/2012 on the Barclays US High Yield Bond Index
4: Based on USD emerging market government debt yielding 1% more than similar duration corporate bonds and 2.5% more than US Treasuries as of 11/30/12 using yield to maturity and option adjusted spread for the JP Morgan EMBI Global Core index’s option adjusted spread over US Treasuries. Looking at data from 11/30/2009 to 11/30/2012, standard deviations of total returns on emerging market debt have been lower than emerging market equities – 7% for USD debt and 15% for local currency debt versus 22% for MCSI EM index.