It’s not news that building a bond portfolio has gotten more challenging. Returns are low and likely to stay that way for the foreseeable future, yet stretching for yield in an uncertain global economy can add substantial risk. Long gone are the days when all you needed was a “set-it-and-forget” core bond fund to provide the income, diversification and capital preservation clients needed.
Bond ETFs have stepped into the breach. In a persistent low-yield environment, financial professionals are paying closer attention to costs and moving toward lower-fee index products such as ETFs. They’re also diversifying beyond core portfolio anchors.
Bond ETFs were introduced nearly 15 years ago, but they have truly caught fire in the past four or five years, making them the fastest-growing ETF category. Global flows reached $50 billion in 2015, a record likely to be surpassed in 2016. This enthusiasm has brought bond ETF assets under management to $586 billion globally and $401 billion in the U.S., as of June 30, 2016.
U.S. fixed income ETF AUM is over $401B
Source: Bloomberg, BlackRock, as of 6/30/16.
In other words, advisors are increasingly recognizing that the core benefits of ETFs can apply to bonds, just they do to stocks.
Heeding the call of flexibility and choice
Financial professionals are incorporating bond ETFs into their broader fixed-income approaches—for both their strategic and tactical allocations, and often alongside active mutual funds and bond ladders. In the first half of this year, nearly $19 billion went to core bond products (generally those seeking to track the Barclays U.S. Aggregate Index); net flows into high-yield ETFs were likewise strong, if more volatile. Cost is a big driver here: Compare the 0.08 percent average expense ratio for Morningstar’s Intermediate Bond ETFs category versus 0.41 percent for comparable actively managed mutual funds; or the 0.47 percent average of Morningstar’s U.S. High Yield ETF category versus 0.75 percent for the mutual funds. (These are Morningstar dollar-weighted averages across share classes, as of June 30, 2016.)
More tactically, bond ETFs are being used to enhance return potential or mitigate interest rate risk. For investors looking for ways to boost yield, we see a lot of interest in municipal bonds. National muni ETFs may help provide tax-exempt interest for qualified investors, although they may still be subject to certain taxes, such as the AMT. (This is in addition to the general tax efficiency of many ETFs.)
We also see investors willing to take on the additional risk of looking beyond the U.S. market, by investing internationally in segments such as emerging market debt, which can add diversified exposures and potentially boost yield. Here, too, ETFs have been a popular implementation tool.
With broader exposure comes broader risk, of course, so investors need to be mindful not only of the impact of interest rates on the value of their bonds, but of risks such as default, volatility and loss of liquidity.
Bond buyers join the ETF migration
There has been yet another transformation that has driven institutional flows to bond ETFs—namely a regulatory environment that has made it more challenging for bond buyers to source individual securities.
New, complex rules have resulted in a sharp reduction in the amount of risk assets banks can hold on their balance sheets. As a result, despite record bond issuance, dealer inventories are sharply lower, as are trading volumes and liquidity. And costs have risen.
Source: Bloomberg, NY Fed, as of 6/30/2016.
These challenges have sent many institutional investors away from the fragmented infrastructure of bond dealers into the arms of bond ETFs, which are traded on an exchange just like stock ETFs. As such, they offer the same potential benefits of intraday trading, price transparency, low cost and added liquidity.
In doing so, they are joining the ranks of the retail community, who were among bond ETFs’ early adopters. We believe these trends are to the good. The broadening sphere of users will help these vehicles become more liquid—a virtuous circle that can help all types of investors navigate the evolving market and regulatory landscapes as they target key financial goals.
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Matthew Tucker, CFA, Managing Director, is the head of Americas iShares Fixed Income Strategy and a member of the Strategy Team within BlackRock's Fixed Income Portfolio Management Team. He leads the product strategy effort for exchange traded funds, and leads the platform's efforts in North and Latin American iShares.
Transactions in shares of ETFs will result in brokerage commissions and will generate tax consequences. All regulated investment companies are obliged to distribute portfolio gains to shareholders. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.
This material represents an assessment of the market environment as of the date indicated; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular. The iShares Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”). iS-18644