Interest rates are low. Credit spreads are tight. Inflation is the highest it’s been in years. Add all that up, and it appears to be a toxic brew for bonds and fixed income exchange traded funds.
Indeed, this is a challenging fixed income environment, but it’s also a time for bond ETFs to prove their mettle, and the asset class is doing just that. Professional investors are taking note and embracing bond ETFs in significant fashion, putting this corner of the ETF market on pace for one of its best years on record in terms of adding assets. There’s room for more growth.
“While 2020 became a milestone for U.S. fixed income ETFs, as they attracted materially greater flows than U.S. equity ETFs for the first time, U.S. fixed income ETFs comprise only 2% of the U.S. fixed income market,” according to Fitch Ratings.
In recent years, more institutional investors flocked to bond ETFs with liquidity being a primary driver of that move. Put simply, many bond ETFs offer more liquidity than individual issues, many of which trade over-the-counter. Owing to robust secondary markets, even bond ETFs tracking less liquid segments such as bank loans, junk debt, and emerging markets are often more liquid than single issue alternatives.
“Investors’ need for liquidity becomes particularly apparent in times of stress such as the COVID-19 driven market downturn,” said Greg Fayvilevich, senior director at Fitch Ratings.
In terms of number funds, the fixed income ETF universe is as big as it’s ever been, and it continues growing as it’s fertile territory for both active managers and index-based strategies. In fact, the bond ETF landscape is likely to continue swelling in size as more active mutual fund managers convert those funds to ETFs. That’s a reminder that all investors should perform adequate due diligence prior to buying a bond ETF.
“ETFs with seemingly similar objectives can have different characteristics and risk/return profiles. Investors’ ability to draw comparisons is complicated by the potential lack of standardization of the key metrics,” notes Fitch.
Bottom line: Expect more fixed income flows driven by professional investors. Do-it-yourself investors can, of course, go along for the ride, but they should commit to some homework to assess how particular bond ETFs fit in their respective portfolios.
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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.