Where are all the bond ETFs?

Why invest in bond ETFs?

Many providers say the impact of central bank's quantitative easing programmes and potential rate rises have driven unprecedented interest in bond ETFs this year. But are there enough products around?

According to BlackRock, the global market in bond ETFs has grown to over $459bn (£292bn) in the past 13 years, and appetite among different investor groups is growing. But in a report into fixed income ETFs released this month, the house says: "Despite significant growth over the last decade, the fixed income ETF market remains small when compared with the cash bond and mutual fund markets."

Andrew Walsh, UK head of ETF sales at UBS Asset Management, says it has taken a while for investors to come around to the idea of fixed income ETFs. He says: "Everyone is aware that there is a case for using passives for equities but people used to think that with fixed income you needed an active manager.

"Actually it's a similar case to equities. Active fund managers after costs generally underperform on average the benchmark. According to a recent Standard & Poor's report, over 75 per cent of actively managed emerging markets debt, high-yield and government bond funds have underperformed the benchmark after costs over one, three and five years."

Clarisse Djabbari, deputy head of global ETFs at Lyxor, says: "I think the area has been lagging because people think of ETFs as equity products. At the moment the MSCI is well known as being a recognised index brand for equity ETFs but there is no one index known for fixed income ETFs."

What's missing?

For UK investors the options available remain limited. There are very few bond ETFs available in sterling form, with the majority listed in euros or dollars, which can hurt your returns. The number of more innovative, smart-beta options is also limited, despite it being an area ripe for innovation.

At a June ETF summit at the London Stock Exchange, Allan Lane, founding partner of Twenty20 Investments, said: "There really isn't a huge choice when you think about the size of the sterling corporate bond market". He said the lack of options in the area was seriously affecting his ability to invest in the right areas, saying "there are gaps in the market and those gaps are hurting us".

Other experts, including Shaun Port, chief investment officer at Nutmeg, Alan Miller, founder of SCM Private, and Christopher Aldous, managing director at Charles Stanley Pan Asset, agree that when it comes to bond ETFs, the menu is too limited.

They particularly want more products that offer currency hedging, which plays a proportionately much higher role in fixed-income ETF volatility and returns than for equity ETFs. Mr Walsh says: "In foreign fixed income investing, currency fluctuations can have a disproportionate impact on your overall investment returns. It's not because currency acts any differently - it's just that they have more of an impact as a proportion of returns because bond returns tend to be lower and less volatile."

Mr Port says: "I think currency hedging is always really interesting and often fixed income is used in low-risk portfolios but with something like buying US treasuries, you might not want to do that on a straight basis because you are taking on currency risk.

"If providers can hedge at a low cost, at around five basis points, then it's worth doing. We also need more sterling-based funds."

Mr Port recommends UBS ETF (LU) Barclays US Liquid Corporate hedged GBP UCITS ETF (UC85) and UBS ETF (LU) Barclays US Liquid Corporate hedged GBP 1-5 UCITS ETF (UC82), both with 0.23 per cent ongoing charges, as good options.

Being smart with fixed income

Another key shortage in fixed income is in the relatively new area of smart-beta strategies, which follow indices other than the main market cap options. The nature of a bond index means that the largest holdings in the index and the most indebted countries, sector or companies which take the largest position, meaning that your biggest exposure is to the most indebted asset. That makes it ripe for alternatively weighted indices.

Ms Djabbari says: "Smart beta in fixed income makes sense and everyone is talking about it but there are few developments."

New kids on the block

Three products launched by Lombard Odier ETF Securities bond seek to amend that. Their new fundamentally-weighted, smart-beta government and corporate fixed income ETFs claim to target more creditworthy borrowers rather than exposing investors to the most indebted issuers.

Salman Ahmed, global fixed income strategist at Lombard Odier, says: "A fundamental approach is based on assessing the financial strength of issuers. This better reflects the creditworthiness of borrowers and is true 'smart beta' for bonds."

The Euro corporate (FWEC), Global Corporate (CRED) and Global Government Bond (CORE) versions of the ETFS Lombard Odier IM ETFs have ongoing charges ranging from 0.25 per cent to 0.30 per cent and give a higher weighting to larger countries and issuers, which the group argues are more capable of paying their debts. However, the ETF methodology also looks at countries' debt burdens and a government's budget and current account deficit and whether public finances are improving or worsening as well as tracking social and political stability.

As a result the ETFs look very different to other fixed-income weightings. For example, the largest exposure of the ETFS Lombard Odier IM Euro Corporate Bond fundamental GO UCITS ETF (FWEC) is to the US at 21 per cent, compared with iShares Core Euro Corporate Bond UCITS ETF (IEBC), which is 21 per cent exposed to France. The ETFs invest in euro-denominated bonds, rather than bonds issued in Europe, so they have exposure to global debt. The ETFS product also has a vastly reduced number of holdings than the iShares product. FWEC has just 190 holdings compared with over 1,600 for the iShares range. With such a short track record performance is hard to compare but in one month both ETFs have returned around 0.4 per cent.

Peter Sleep, senior portfolio manager at Seven Investment Management, is sceptical of the model, which he says includes too many factor screens. "It's a complicated strategy and could be over engineered," he says. "This is very much research-based smart beta."

"I think the fundamental weighted indices like Lombard Odier's may pick up on things like value and defensiveness but I'm not sure they do it in a systematic fashion and think there are so many metrics that any value or momentum or defensiveness screen is diluted by the other metrics."

Mr Port also warns that while fixed income smart beta might look appealing, any move away from a market cap strategy could throw up issues of liquidity and hit you with trading costs. "Transaction costs are tricky here," he says. "If you move, for instance, to an equally weighted index, you will have a higher weighting in smaller issuers and less liquidity in what you're trading, so you will have higher transaction costs."

Best options for playing ETF fixed income

Bond ETFs have the benefit of being a very targeted way to play the bond market. But that does mean that you might need to be more vigilant about your investments than with a broader, actively managed bond fund.

Mr Port says: "We like to use them because there's a lot of precision - you can choose financials, non-financials, different maturities and credit risks. It's quite a wide set of tools."

"We expect a positive total return better than cash. The return from corporate bonds over the past 10 years is around 6 per cent annualised, and 2-3 per cent from corporate bonds would be a good result but these ETFs are paying reasonable yields of around 3 per cent."

The key issue is managing duration risk, with shorter-dated bonds likely to be hit badly by a rise in interest rates. Mr Port says: "We've been very careful about how we manage duration risk and that's where ETFs are great because you can switch into shorter date corporate and government bonds.

"We're also worried about general liquidity in investment-grade bonds across the board so are reducing corporate bond exposure and moving much more into short maturity corporate bonds. In that space you've got a choice between iShares and SPDFR. We are big fans of SPDR funds and sometimes it's a choice of index - iBoxx or Barclays index."

Mr Port likes SPDR Barclays 0-5 yr Sterling Corporate Bond UCITS ETF (SUKC). He says: "It is a short-dated corporate bond fund - it's a nice low steady cash plus corporate bond fund. There is the potential for capital loss but I think it's a nice low-risk ETF."

The fund was launched in 2014 and has a dividend yield of 2.38 per cent. Mr Sleep likes the much longer-dated iShares Core £ Corporate Bond UCITS ETF (SLXX), which tracks the Markit iBoxx £ Liquid Corporates Long-Dated Bond Index. It has an effective duration of almost nine years but does carry a yield of 3.42 per cent.

Mr Sleep argues that the best strategy with bond ETFs lies in diversification. He says: "We would suggest a little high yield and emerging markets debt and a bit of sovereign debt. SLXX is an income-producing asset. It's low income but relatively safe. High yield will give you more income but it's volatile and emerging markets debt in a local currency is really interesting because it will behave a bit like high yield but behave in unpredictable ways, making it a great diversifier."

He likes iShares $ High Yield Corporate Bond UCITS ETF (IHYU), with a yield of 5.79 per cent and ongoing charge of 0.5 per cent. It tracks the Markit iBoxx USD Liquid High Yield Capped Index, which consists of the most liquid USD denominated corporate bonds with a sub-investment grade rating. As well as the high yield it has returned 5.4 per cent in the year to date, according to Morningstar.

Performance (% total return) and yield of recommended bond ETFs*

*Lombard Odier products not included due to limited track record

Source: Morningstar, as at 29 June 2015