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Bond ETFs skyrocketing in 2016

Carl-Christian Höeg, Director, ETF Scandinavia, Lyxor Asset Management.

ETFs continue to resonate with investors as they are low cost, transparent, diversified and rules-based. Fixed income ETFs in particular are clearly growing in popularity.

ETFs continue to resonate with investors as they are low cost, transparent, diversified and rules-based. Fixed income ETFs in particular are clearly growing in popularity: Lyxor data indicates that in 2015, the asset class gathered USD 28.9bn in net new assets, a three-year record high accounting for 35% of all European ETF inflows.

As at the end of 2015, fixed income represented a quarter of the ETF market with USD 123.5bn in assets under management. More recently, fixed income ETFs have already gathered over USD 25bn in net new assets year to date.*

Cumulated Net New Assets (EUR M) on Fixed Income ETFs in Europe*

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*Source: Lyxor International Asset Management, Bloomberg. Monthly data in EURM from 03/01/2013 until 31/08/2016.

Three major factors are driving this growth. The first is the macro environment. Low interest rates are herding investors towards corporate bonds, while increased market volatility is making traditional safe haven assets like gilts more attractive. The second is the fact that investors are now spoilt for choice with the universe of ETFs available. From government bonds to corporates, investment grade to high yield, short dated to long dated, and developed markets to emerging, investors can express their credit, duration and market views with increasing granularity. Finally, new users such as pension funds and insurance companies are using fixed income ETFs more and more. Research from Greenwich Associates shows that these institutions use ETFs for strategic allocation and diversification purposes. 

What’s the benefit of using ETFs as a wrapper to access fixed income?

Although some bonds like govies can be traded on-screen, they are typically traded over-the-counter via an interdealer broker. This is especially true for corporate bonds, and it is an opaque process compared to equities that trade intraday on regulated exchanges. The ETF wrapper democratises the process. All investors, whether they are trading one share or €1m worth, will receive the same terms with regards to management fees, liquidity conditions and transparency. 

Ultimately, and as their name indicates, ETFs bring an additional layer of liquidity by virtue of being traded on exchange (the ‘secondary market’). We saw that in periods of market stress such as in 2008 and 2011, ETF investors benefited from the ability to get in, and critically, the ability to get out of their fixed income positions. That said, in highly stressed markets the liquidity of an ETF will be limited by the underlying liquidity. This means that if the liquidity of the underlying bonds deteriorates as a result of a heavy sell-off, ETF holders may be affected.

What are the key features investors should consider when selecting a fixed income ETF?

The number one consideration in choosing a fixed income ETF should always be the selection of the index. Investors need to understand how different benchmark factors drive the risk and return profile. For example, emerging markets debt in local currency will perform very differently from USD denominated debt. The number of constituents equally plays a part; some indices are broad with thousands of underlying bonds, while others are far narrower in scope. 

Beyond benchmark selection, the standard ETF features need to be considered. What’s the track record of the ETF in terms of tracking performance? Is it tracking the index consistently, or does it exhibit high tracking error? What’s the total expense ratio? How liquid is the ETF? Where is the fund domiciled, and so forth.

Worth remembering is that ETFs are not a magic wrapper; they are ultimately only as liquid as the underlying composition. That is why index providers and ETF issuers spend significant amounts of time studying the underlying and designing the products to ensure they meet the hallmarks of an ETF: low cost, liquidity, and transparency.

How is Lyxor helping investors access fixed income ETFs?

Lyxor is the 2nd largest physical fixed income ETF provider in Europe, managing over USD 12.2bn in total fixed income ETF assets with over 45 ETFs across govies, corporates, high yield, emerging markets debt, inflation-linked, as well as short and leveraged products. Many of these are available in various duration buckets, currencies and geographies.**

Aside from our differentiated product suite, we differ from most of our peers in that we are structure agnostic. For example, we do full physical replication for developed markets government bonds without securities lending, as these are highly liquid instruments and the additional risk of securities lending does not add sufficient benefit for investors. On the other hand, for our corporate bond range, we use synthetic replications to get tighter tracking performance on this less liquid side of the market. Currently, 53% of our fixed income ETF assets are managed using physical replication.**

In a low yield environment, costs can significantly diminish the return received by investors. Accordingly, in February this year we announced an aggressive fee cut to our US fixed income ETFs. These cuts mean that investors can get dramatically better performance. Our US treasuries ETFs now have a total expense ratio of 0.07%, making them at the time of writing the cheapest in the European market and approximately a third of the cost of commonly used competing ETFs at the time of writing. Additionally, we cut the fee of our US investment grade corporate bond ETFs to 0.09%, also the cheapest available in Europe and approximately half the cost of competing products at the time of writing. We also launched a US TIPS ETF in August at just 0.09%.

Going forward, we will continue adding to our product suite, filling in gaps in order to meet client demand.

**Source: Lyxor International Asset Management, as at 27/06/16.

VIDEO: When do ETFs have a part to play in portfolios?

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Watch Lyxor answer questions from investors on how to use fixed income ETFs in their portfolios in this video interview.

Contact information

For more information about Lyxor ETF, please email info@lyxoretf.se

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