Editor's Note: This blog has been updated to include more recent data. It was originally published in September 2018.
As ETF assets have grown exponentially over the past decade, fixed income ETFs have increased in lockstep. As shown below, fixed income ETF assets under management have seen explosive growth since 2002.
Source: Morningstar as of 6/30/2019.
Not only have fixed income ETF assets increased but so too has the investor base using these funds. Wealth management and institutional investors are projected to increase their use of fixed income ETFs over the next few years, according to reports from Cerulli1 and Greenwich Associates,2 adding to an expanding and evolving user base that includes individual investors and financial advisors.
What is driving more investors to use ETFs for fixed income exposure? I’ve summarized the key reasons below.
ETFs’ unique characteristics enable investors to:
- Lower costs: US-listed fixed income ETFs have a median expense ratio of 0.25% versus mutual funds’ median ratio of 0.6%. While many ETFs are index-based, this lower cost profile carries over to actively managed ETFs that have a median expense ratio of 0.41% versus 0.68% for actively managed bond mutual fund strategies.3
- Improve liquidity: ETFs’ robust secondary market means investors can tap into market liquidity more easily than with single-CUSIP bond holdings to reallocate portfolios quickly across asset classes or meet investor redemptions by selling an ETF position into the market without having to sell single-CUSIP bonds.
- Increase transparency: Both index-based and actively managed ETFs report holdings daily, increasing transparency for investors performing daily portfolio due diligence and attribution for risk management.
- Target duration: ETFs precisely cover the entire term structure along the yield curve, so investors can fine-tune a portfolio’s interest rate risk (duration) to match market views.
- Modulate credit risk: Ranging from investment grade credit to crossover debt to senior loans to high yield, ETFs allow investors to control the amount of credit risk in a portfolio with ease and transparency.
Supporting strategic and tactical strategies, fixed income ETFs allow investors to:
- Be active with an index: Using the vast array of ETFs to optimize portfolios for precise yield, duration, spread and sector, or even to simply re-weight sectors of the Bloomberg Barclays US Aggregate Index (the Agg), investors can create custom portfolios across a wide array of bond sub-sectors.
- Seek active management: More than 110 actively managed bond ETFs have launched in the US over the past ten years and as a group now have more than $61 billion of assets under management. Some of these ETFs now have 3-, 5- or 10-year track records.4
- Replicate beta: The expansion of liquid ETF products supports more adaptable beta solutions to equitize cash or provide easy reinvestment of accumulated coupon payments.
- Target trends: Investors can seek alpha by rotating efficiently in and out of asset classes based on macro, technical, or fundamental trends. For example, an investor could choose to use a fixed income ETF to rotate into emerging market local debt in a declining rate and softer dollar environment. Alternatively, an investor could opt to short ETFs to make relative value trades—such as loans over high yield—by executing just two CUSIPs.
Fixed income ETFs support these additional uses in a portfolio:
- Derivative alternatives: Fixed income ETFs provide alternatives to total return swaps and credit default swaps indices. Also, investors can tap into nearly $70 billion of ETF option notional value open interest on fixed income products for risk mitigation,5 income generation or more advanced strategies.
- Transfer of assets: ETFs’ unique creation and redemption process and the breadth of securities owned by ETFs allow large investors holding single bonds to leverage the in-kind creation and redemption process to efficiently transfer select underlying bonds on their books into an ETF.
- Transition management: Index-based fixed income ETFs can be used as temporary placeholders to obtain market exposure while searching for a new manager. ETFs’ in-kind creation and redemption process can facilitate the implementation of the new strategy.
- Inventory consolidation: Sell-side brokerage firms can use fixed income ETFs to manage the inventory held by their trading desks, consolidating positions across traders, and move bonds off their books by creating ETF shares they can sell in the market.
From the extensive list above, it’s clear that fixed income ETFs can play multiple roles within a portfolio. At SPDR® ETFs, we pride ourselves on providing tools and insights that can help investors construct the best portfolios for meeting clients’ long-term objectives. We also remain committed to providing education on the wrapper within the asset class, including de-bunking some of those well discussed, but misinformed, myths that may be holding investors back from implementing fixed income ETFs into portfolios, such as:
- Index investing is distorting the bond market
- High yield ETFs are bad for the market, part one and two
For more insights on using fixed income ETFs in the portfolio construction process and creating flexible and customizable fixed income portfolios, be sure to follow SPDR Blog.
1"Bond ETFs: Financial Advisors Drive Use With Specialized Applications," Cerulli 2017
2Morningstar, as of 06/30/2019
3Morningstar, as of 06/30/2019
4Morningstar, as of 06/30/2019
5Bloomberg Finance L.P., as of 08/22/2019
A gauge of risk-adjusted outperformance relative to a benchmark.
Measures the volatility of a security or portfolio in relation to the market, usually as measured by the S&P 500 Index. A beta of 1 indicates the security will move with the market. A beta of 1.3 means the security is expected to be 30% more volatile than the market, while a beta of 0.8 means the security is expected to be 20% less volatile than the market.
Bloomberg Barclays US Aggregate Bond Index (the Agg)
A market-weighted index, meaning the securities in the index are weighted according to the market size of each bond type. Most US traded investment grade bonds are represented. Municipal Bonds and Treasury Inflation-Protected Securities are excluded, due to tax treatment issues. The index includes Treasury, Government agency bonds, Mortgage-backed bonds, Corporate bonds and a small amount of foreign bonds traded in the US.
Creation and Redemption Mechanism
The process by which ETF shares are created and redeemed. The creation process involves authorized participants (APs) buying underlying shares and delivering those shares to the fund sponsor in exchange for equally valued ETF shares. The redemption process is the reverse, wherein the AP removes ETF shares from the market and exchanges those ETF shares with the ETF sponsor for an equally valued amount of the ETF’s underlying shares. These in-kind transfers help explain the tax efficiency of ETFs as well as their relative.
Stands for the Committee on Uniform Securities Identification Procedures. Formed in 1962, this committee developed a system that identifies securities, specifically U.S. and Canadian registered stocks, U.S. government and municipal bonds, exchange-traded funds and mutual funds.
The income produced by an investment, typically calculated as the interest received annually divided by the investment’s price.