Fixed Income ETFs: Fact vs. Fiction (Part 2)
Exchange-traded funds (ETFs) are quickly establishing their importance in providing institutional investors access to fixed income.
Despite their growing popularity, several misplaced concerns about fixed income ETFs remain. We will investigate the most pervasive ones, aiming to separate fact from fiction. This is the second part in a two-part series breaking down the fact from fiction that surrounds the fixed income ETF markets.
To read part one, click here. A new survey of institutional investors by Greenwich Associates1 reveals that 24% already have a stake in Asian fixed income ETFs, making them the most popular passive fund option. A further 22% are also considering adding them to their portfolios – giving these funds the highest potential growth rate among all possible investment vehicles.
MISCONCEPTION 4: FIXED INCOME (FI) ETF INVESTORS ARE OVERWEIGHT THE RISKIEST COMPANIES
One common misconception is that fixed income ETFs are overweight the most indebted companies, leaving investors holding exposure to the riskiest firms. While this is an understandable concern, it is not true.
An ETF’s index construction inherently provides diversification benefits and often employs constituent capping to mitigate concentration risks. In addition, large issuers of debt are companies with substantial asset bases and revenue profiles. This provides the ability, or the capacity, to pay and service the debt on the firm’s balance sheet. Focusing only on the amount of debt an issuer has in an index overlooks a few key variables.
Indices are rules based and focus on diversification and liquidity to ensure investability. As a result, not all of an issuers’ debt is included in the index, which paints an incomplete picture of the firm’s overall indebtedness. For instance, an issuer can have short-term liabilities that do not qualify it for inclusion in an index, or debt financing secured in subordinated form, or financing denominated in a different currency.
In fact, companies with a higher level of debt do not necessarily always pose greater risk than businesses with less debt, nor do they have less capacity to pay. If this was the case, there would be a clear linear relationship between debt issuance and credit ratings. However, credit rating agencies consider several factors beyond the debt level, including the capacity to service debt.
MISCONCEPTION 5: THERE ARE TOO MANY BONDS TO MAKE FI INDEX INVESTING EFFICIENT
While investors are increasingly noting the advantages of passive investing, some still believe that it is not suitable for fixed income investing, simply due to the sheer number of bonds in an index. In reality, the objective of an index investment manager is not to hold every single issue in the index, but rather to seek to track an index’s return with minimal tracking error.
Sampling can be the most efficient technique for constructing portfolios, as many broad fixed-income indices include a large number of securities, but not all of those securities can be purchased. Coupled with potentially high transaction costs to access illiquid bonds, full replication isn’t always possible or practical.
With a sampling approach, an investment manager would aim to replicate the key characteristics of duration, curve and issuer credit exposure of the index.
There are two main approaches to minimise tracking error - top-down and bottom-up. While the former approach seeks to align the common factors of the ETF to the index, the latter is often used in markets such as high yield, where there is usually greater price volatility.
MISCONCEPTION 6: FI ETFs ARE DIFFICULT TO TRADE
Some of the key benefits that are attracting institutional investor attention to fixed-income ETFs include liquidity, diversification and lower costs. In addition to this, 44% of respondents in the Greenwich Associates survey stated the ease of execution without the complex due diligence process as another main attraction of these investment vehicles. Complexity varies depending on the needs of the investor, but there are two straightforward ways to access fixed income ETFs – through exchange liquidity or over-the-counter (OTC) liquidity.
When considering whether to trade on exchange or OTC, it is important to consider trade size. As you would expect, similar to single stock equities, larger trades that exceed average daily volume should be handled with greater care by working with a broker dealer or market maker OTC.
Investors also value ETFs for their transparency, as ETF issuers typically publish daily pricing reports that include principal, interest, cash and accrued interest/undistributed income, such that any investor is able to price the ETF.
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[1] State Street Global Advisors commissioned Greenwich Associates to conduct a global study of 151 institutional investors and 36 intermediary distributors from Asia Pacific, Europe and the United States between October 2018 and March 2019.
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