ETF: The New Fixed Income Assets Darling?

uch of the current concern in the investment markets surrounds the potential for liquidity to dry up in global bond markets. This has resulted in massive amounts of liquidity being injected into the fixed income markets as a response to the current financial crisis and global economic slowdown.
Currently, the markets are experiencing record levels of new bonds being issued as many issuers seek to lock in super low-interest rates. Keeping all this in mind, how does this situation impact investors wanting to incorporate stable allocations of fixed income ETF assets in their portfolios?
It’s important to remain grounded during a fluctuating market—there are substantial structural changes that are taking place in the bonds market. This is causing a lack of liquidity when investors are buying and selling—it’s likely that this may be an issue that affects the market for some time.
This has caused pensions globally to work and match assets and liabilities by simply locking into matching bond positions. Often, these fixed income trades are large and considered ‘one-and-done’ trades. The intent being to hold the position to maturity. The last five years or so have been characterized by investors buying bonds and bond funds—with only occasional hiccups attributed to interest rate hike alarms.
The more that volumes slow, the more that we see a loss of intermediaries that are standing between the supply and demand. This means that buyers and sellers both can expect choppier waters. The good news? Much of the buying in retirement, insurance, and mutual funds are light on the leverage scales—reducing the magnified effects of a sell-off.
It can also be argued that a new class of fixed-income investor can take the spotlight in the event of a bump in interest rates. These value-oriented investors could create a new source of liquidity that we haven’t seen as much strength in recent years.
To no one’s surprise, institutional investors and financial managers have been implementing various workarounds, addressing liquidity and maintaining control over fixed-income allocations in their portfolios. Some of these tactics—the use of futures and derivatives, for example, have been available for years. The use of ETF products, however, have only begun picking up steam in more recent times.
Although it’s true that fund managers were using Treasury futures or credit default swaps as proxies for actual bond holdings before the current economic slowdown, in many cases, it wasn’t due to liquidity as much as it was ease and flexibility.
A major player in the spotlight more and more frequently is the use of bond ETFs—usually, as replacements for long holdings of the bonds themselves.
However, ETF products in specific sectors—like corporate debt, are proving to enjoy more liquidity than their underlying holdings.
Provided that there aren’t immense amounts of pressure to buy or sell any given instrument, these ETF offerings can provide much-needed exposure and liquidity to a wide range of different investor classes. They also provide inherent diversification for any given exposure—which may be appealing to a large number of investors. So, this begs the question—is everything in the fixed-income markets fine? Has the bond market liquidity issue been solved?
Hold tight. Recent studies question the stability of these particular liquidity solutions—credit default swaps have a fairly shaky history of running beyond the notional basis of the derived value.
There’s also the issue of a mob-mentality alarm and run for the exits in the bond market. All investors that are more concerned about near-term value will rush to sell at the same time, pushing massive sell orders into a system with few buyers.
This could result in a huge gapping of spreads—greatly reducing valuations for bondholders. This could be a bad situation.
There are no easy answers for any investor, but the questions may be especially tricky for fixed income investors that are engaged in more short term or tactically oriented strategies. This new environment creates risk for these particular types of trading profiles.
Not all is bleak—things can be promising if your clients are long-term focused investors. If their intent is to reach a goal some point down the road and they are not worried about accessing the invested principal until then, your clients can largely ignore this worry. These investors can just buy good quality bonds in sectors and durations desired and allow them to ride through to maturity.
There are some products—like unconstrained fixed income bond funds and floating rate funds, that may weather volatile markets much better than core bond fund products.
High-yield may fare better than higher quality issues in this sort of caustic environment—their profile is more aligned with equities that perform better when the economy perks up.
All of these are avenues that could potentially be viable investment products for your clients that wish to build a fixed income position, but a general rule of thumb, first: keep the duration as tight as possible. Avoid overt crest risks—especially in sectors that are vulnerable to rising rate environments like specific emerging markets. Like most investment strategies, diversify, stay as liquid as possible, and invest for the long term when using ETFs for fixed income situations.