For investors and advisors, planning for income has been a consistent and escalating challenge for more than a decade. More recently, we have seen a yield curve inversion, a recession, and the 10-year treasury drop to a historic low at just over 0.50%. Today, plan implementation with traditional bonds is as challenging as it has ever been while inventories are light, spreads are tight, and yield is hard to come by. At the same time, we have seen a massive rise in the availability and adoption of fixed income ETFs as a viable alternative to achieve diversified exposure in the fixed income markets. In fact, according to Bloomberg, U.S. fixed income ETF assets are nearing $1 trillion (exhibit 1). Additionally, fixed income ETF growth has spanned all areas of the fixed income market and now offers easy access and diversification opportunities previously not readily available to individual investors. In the following article, we will consider the benefits of fixed income ETFs to diversify exposure and offer liquidity, as well as the use of active management to provide opportunities to tactically manage fixed income allocations across sectors not easily replicated through individual bond portfolios.
Practitioners of portfolio construction understand that diversification across asset classes, market capitalizations, and global regions are the basis for sound portfolio construction. However, many investors spend a lot of time focused on diversifying equity and very little on fixed income. In fact, diversification is perhaps the biggest challenge individual fixed income investors face when trying to construct portfolios using individual bonds. Often, we see the use of corporate, municipal, or some other single type of issuance where size limitations make it difficult to diversify sector and individual issuer risk. This is where ETFs may provide some viable solutions by providing access to expertise and scale in a diversified product that trades in the open market.
As an example, an investor could create a portfolio to include ETFs across multiple fixed income types, disciplines, credit qualities, and maturities with just a handful of purchases. It is now possible with just a few trades to gain diversified exposure across mortgage-backed securities, municipal bonds, corporate bonds, convertible bonds, Treasury Inflation Protected Securities (TIPS), and dividend equity. The ETF format makes it easier to create a portfolio that can generate yield while also controlling interest rate sensitivity and other risks through weighting and rebalancing.
Active management is another interesting feature of ETFs. In this case, active management is the ability for an investor to tactically buy or sell a specific ETF representing part of the fixed income market, or use ETFs with managers that actively managed the exposures within their product. In both cases, ETFs provide a simple and expedient way to align portfolio positioning with an overall market outlook. Active management can be extremely important in the management of risk, especially within the fixed income landscape. Mortgage-backed securities are an excellent example of this point, whereby the economic and interest rate environment can have a significant impact on this sector through prepayment, extension, and default risks. This is just one example of an actively managed sector. ETFs now provide much more than simple index replication. Today, one can find ETFs across the spectrum of fixed income and target a strategy based on an outlook whether you are attempting to mitigate risk or take advantage of an opportunity.
Liquidity has long been a concern in the fixed income markets, particularly in highly stressed and volatile periods like that of 2007-2008 and more recently in 2020. It is important to acknowledge that whether an investor uses individual bonds or ETFs, market conditions can expose bond investors to liquidity constraints. That was certainly the case in 2020 when liquidity for even high quality bonds came into question.
However, as a result of the growth and widespread adoption of fixed income ETFs, the category held up exceptionally well in these volatile markets. That is not to say that the underlying bonds in an ETF are not subject to the same challenges. However, with intra-day trading and an active ticker symbol with a price, fixed income ETFs can provide real price transparency and a liquid market. In addition, ETFs have institutions serving as authorized participants who, much like a market maker, commit to keep a fair and orderly market as they manage the creation and redemption process. An authorized participant has the ability to take ownership of and hold bonds in the redemption process, which provides liquidity to an ETF investor.
Whether an investor is using fixed income to generate a flow of income or mitigate risk, asset allocation and diversification is the foundation of sound portfolio construction. Today’s fixed income markets provide an array of diverse tools to accomplish almost any goal. Whether using individual bonds, alternative investments, or fixed income ETFs, asset allocators now have greater flexibility and opportunities for diversification than ever before. Finally, viable strategic and tactical tools exist that allow investors to more efficiently navigate even the most challenging times by expanding the available universe of fixed income options.
DISCLOSURES
Any forecasts, figures, opinions or investment techniques and strategies explained are Stringer Asset Management, LLC’s as of the date of publication. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect to error or omission is accepted. They are subject to change without reference or notification. The views contained herein are not to be taken as advice or a recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested.
Past performance and yield may not be a reliable guide to future performance. Current performance may be higher or lower than the performance quoted.
The securities identified and described may not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable.
Data is provided by various sources and prepared by Stringer Asset Management, LLC and has not been verified or audited by an independent accountant.