How ETFs have spread into fixed-income markets

Key Takeaways

• Investors are drawn to ETFs’ versatility, liquidity and low costs
• Active ETFs are growing fast as investors seek out-performance
• Popularity of ETFs goes hand-in-hand with market electronification

Markets have evolved greatly in the past decade, with geopolitical uncertainty, volatility and ever-tightening regulations dovetailing with technological developments and demand for greater investment flexibility and transparency.

For investors seeking fixed-income exposure, bond exchange-traded funds (ETFs) are a convenient tool, offering a combination of liquidity, diversification, and real-time trading. They comprise a diversified portfolio of bonds, which, like equities-based ETFs, typically (but not uniquely) track an index passively. The low-maintenance approach keeps costs down, which makes them affordable for those in search of a simple, long-term investment strategy.

As technology reshapes the landscape of fixed-income markets, ETFs are on their own particular journey, growing fast and evolving from mostly passive instruments into a popular active trading strategy.

Active ETFs aim to outperform a benchmark index or have a niche focus and make regular adjustments in holdings based on market insights. The fees are typically higher. According to ETF.com, the popularity of active ETFs is increasing due to market volatility, product innovation and investor demand for potential outperformance.

It’s no wonder that Oliver Wyman says ‘We believe the ETF landscape is just embarking into a next stage of growth — this time fueled by the rise active ETFs. By 2027, ETFs will account for 24% of total fund assets, up from 17% today.’

Bond ETF opportunities and risks

ETFs offer more flexibility to investors and can be traded like individual stocks whenever the market is open. But, as with any investment vehicle, there are risks.

The opportunities include:

• Risk management: RBC Global Management outlines how investors can manage their risks with ETFs, which comprise a diversified portfolio, often hundreds of bonds. This wide exposure reduces the risk of market fluctuations.
• Enhanced cash flow: Bond ETFs boost the cash flow of investors through regular interest (coupon) payments. In contrast to individual bonds, which pay coupons every six months, bond ETFs usually pay interest monthly.
• Bypass individual bond scrutiny: CMCInvest highlights how bond ETFs eliminate the need to scrutinize numerous individual bonds and offer investors the flexibility to choose the desired characteristics of bonds for their portfolio. Again, this dynamic investing helps diversify the portfolio with the appropriate balance of risk and return.
• Low investment threshold: Gone are the days when investors had to start investing in bonds with a minimum of USD 1,000 for individual bonds or USD 200 for corporate bonds, as entry in bond ETFs is akin to acquiring a stock at its current market price.

A few of the challenges investors must be aware of are:

• Market risk: Fidelity Investments explains bond ETFs as just a wrapper around their underlying assets. If the underlying index drops by, say, 50%, no matter how cost-effective, tax-efficient, or transparent the ETF is, it wouldn’t shield the investors from the loss.
• Exotic-exposure risk: ETFs provide access to a wide range of markets, from stocks and bonds to commodities and complex strategies like currencies and options. However, that doesn’t reduce the complexity or risks associated with market fluctuations.
• Expense ratios: Fund management fees, though competitive, can still eat into the interest earned by the holdings.
• Capital risks: While bond ETFs offer access to a wide range of options, there are no guarantees regarding the security of the principal. In the event of sudden market drops, the entire capital could be wiped out.

The growing influence of ETFs

With the rise of bond ETFs, credit portfolio trading has flourished. This involves trading a basket of bonds as a single, all-or-none transaction and is a strategy designed to generate liquidity efficiently, especially in relatively illiquid and high-yield bonds. It is a faster and cheaper way to shift bundles of securities than over-the-counter trading, bond by bond. In portfolio trading, dealers unpack an ETF to create a more customized basket of securities and mitigate risk by hedging the bundle against the ETF. Price transparency is at the heart of it. As ETFs trade throughout the day, they are a powerful price discovery tool for the underlying bonds.

The efficiency, flexibility and diversity of ETFs make them well-placed to tap investor resources and new money. More so now that active ETFs are booming. Research company ETFGI said fixed-income ETFs saw net inflows of USD 34.53bn in August, bringing year-to-date net inflows to USD 219.03bn versus USD 184.11bn (YTD) in 2023.

The rising popularity of bond ETFs is a watershed moment in bond investing, according to Blackrock. After a tough year, yields have rebounded across most fixed-income sectors and, consequently, there’s been a notable shift towards fixed-income assets.

“Global bond ETF assets are approaching USD 2trn; all of these reinforce our belief that global bond ETF assets will reach USD 6trn by 2030, and likely even sooner,” the Blackrock report said.

Technology catches up with fixed income

Fixed income has hitherto been slower than other areas to adopt modern technology, with voice and bilateral communications continuing to play a big role, whereas electronification in equities advanced earlier.

But the sector is catching up, with 49% of US investment-grade corporate bond trading now being electronic, and a Coalition Greenwich report says the sector ‘now is moving onto phase 2—automation’.

According to TheTrade, algorithms driven by artificial intelligence (AI) can also play an important role in bond ETFs by enhancing investment strategies and improving operational efficiency. The technology can analyze huge amounts of data to identify the best bonds for inclusion in an ETF and make smarter, data-driven investment decisions.

Nevertheless, with market participants merely at the start of their journey with AI, the popularity of ETFs means that automation and front-to-back workflow integration are the most viable options today for trading desks to handle the massive volumes of transactions and data.