Many bond strategies can now be replicated using exchange traded funds (ETFs) and in Europe alone €120bn is invested in fixed income this way. Portfolio managers are using the products for core bond exposure; as a diversification tool (to gain simple access to corporate or international sovereign debt); and also as a tactical tool, to swiftly alter bond allocations in response to macro events, such as European Central Bank (ECB) policy announcements. Another reason for the growth in fixed income ETFs, is that some money managers believe the secondary market in the funds themselves adds an additional layer of liquidity.
There are several considerations when assessing the liquidity of a bond ETF. Trading volumes of the fund itself can improve the tightness of spreads when buying and selling units but the liquidity of underlying bonds will impact performance and tracking accuracy. Of course, the same fundamental liquidity issues affect bond mutual funds and a growing number of investors prefer the flexibility, low costs and cheap spreads offered by ETFs.
Bond basics
Bonds have an important role to play in a balanced portfolio. As well as offering a stable income stream, they have been negatively correlated with share prices throughout much of the last century-and-half. The basic concept of investing in a single bond is straightforward, investors receive a string of coupon payments and the par price of the bond at redemption. In practice, most investors will buy a bond mutual fund where the managers will trade numerous (often hundreds) of bonds to make profits if prices rise and look to reinvest capital gains and coupons at the best rate, to achieve the highest total return.
There are two return components to a bond, the coupons paid and the redemption value of the bond. The issue price of the bond is its ‘par’ value and the coupon is a percentage of par. The sum of the coupon does not change but as investors’ required rates of return fluctuate, the price of the bond in the secondary market will deviate from par. This has the effect of altering the nominal or ‘flat’ yield (coupon divided by market price) and explains the inverse relationship between yield and price.
A more useful measure of the yield on a bond (especially for longer term investors) is the gross redemption yield (GRY). This takes into account net present value (NPV) of remaining coupons and the final redemption amount (equivalent to nominal par value). It is effectively the internal rate of return (IRR) of the bond i.e. the discount rate that, when applied to the future cash flows, produces the current price of the bond. The pricing of bonds on the secondary market is demonstrated in the table below:
Discounting cash flows by GRY to price a bond
This example assumes a gilt (UK government bond) with three years until maturity. The par value is £100 and the annual coupon is 5 per cent. The convention is for gilt coupons to be paid every six months, so there would be two payments of £2.50, for the purpose of this example, however, one annual £5 coupon is assumed.. In year three, the investor will also receive the £100 redemption. The required GRY in this example is 6 per cent, which is higher than the coupon rate. This means that this bond will trade at a price below par.
| Annual cash flow | Cash flow (£) | Discount factor (GRY 6%) | Discount factor at desired yield | Present value of cash flow |
| 1 | £5.00 | [1/1.06]^1 | 0.94 | £4.72 |
| 2 | £5.00 | [1/1.06]^2 | 0.89 | £4.45 |
| 3 | £105.00 | [1/1.06]^3 | 0.84 | £88.20 |
| Bond Price | £97.37 |
Risks of fixed income investments
Two of the most important reasons that bond prices change are the credit worthiness of the issuer and the bond’s sensitivity to interest rates. The first point is easily explainable, investors will pay less for a bond if they feel the capital is more at risk and will demand a higher yield as compensation for less certain re-payment.
The relationship between bonds and interest rates requires more explanation. As rates rise, so do required returns. This means that the price of bonds with coupons below the new GRY will fall, in order to match the rate demanded by the market. For investors holding a single bond to maturity, in a sense, the falling price on the open market doesn’t matter. After all, provided the bond issuer remains solvent, capital will be repaid and coupons issued, so they will not suffer a loss in nominal terms.
There are, however, some risks in this scenario. Firstly, there is an opportunity cost as the investor could have waited and bought a higher yielding bond with similar credit risk. Secondly, higher interest rates are likely to be in response to an inflationary environment. If the value of future cash flows is diminished, the investment may underperform in real terms.
In practice, most investors will use bond funds and it is in this scenario that price risk becomes more of a problem. The value of the units held are determined not only by income from coupons and redemptions but also the current market price of holdings. This means that falling bond prices seriously undermine total performance.
Bond fund managers carefully monitor the interest rate risk in portfolios and the main measures of risk is the ‘duration’ of a bond. There are several factors that contribute to the interest rate sensitivity of individual bond prices including, the time until maturity, the coupon and the yield. Some general maxims exist, around the time until redemption and size of coupon, but the most reliable measures for composite risk are the Macaulay duration and the modified duration of a bond.
The duration devised by Frederick Macaulay is in effect the weighted average of present values of all of a bond’s cash flows. The duration is measured in years and the longer the duration, the more sensitive the bond is to interest rate changes. Bond fund managers will look to match nominal liabilities to durations in a strategy known as ‘immunisation’. As the Macaulay duration is the effective maturity of the bond, immunisation enables managers to try and take account of sensitivity to interest rates and ensure there is no capital short-fall as liabilities fall due.
An important point to note, is that the duration of a bond is not the same as its time until redemption. For example, a five year bond could have a duration of four-and-a-half years. It is the duration that managers will pay most attention to as an indicator of the bond’s risk.
The modified duration is another extremely useful measure of a bond’s interest rate risk. Its purpose is to estimate the percentage change in price in response to a one per cent movement in GRY. The modified duration is only an estimate, as the relationship between price and yields is not perfectly linear. Therefore the modified duration is adjusted by a measure of the convexity in the relationship between price and yield for a particular bond.
Liquidity
Another concern for bond managers is the ease with which an issue can be bought and sold in the open market. In certain market conditions, the volume of trading can concentrate into benchmark bonds or the most recent ‘on-the-run’ bond issues, this can render other issues illiquid.
The most famous example where this caused systematic problems was in 1998 when, following the Russian debt default, a breakdown in market confidence caused investors to horde on-the-run US treasuries, resulting in a price misalignment with similar bonds that had only slightly different maturity dates. The impact was a breakdown in complex strategies designed to exploit the spreads across the bond market yield spectrum. This led to the collapse of multi-billion dollar hedge fund Long Term Capital Management (LTCM), which had reverberations throughout the global financial system.
Bond ETFs and portfolio decisions
As well as the main risks of issuer solvency, interest rate sensitivity and liquidity, bond fund managers have to contend with issue-specific risk (for example, callable bonds might be redeemed early by the issuer if interest rates fall). There are also currency and tax risks for bonds issued from different countries and jurisdictions. Multiple risk factors are considered in construction of fixed income ETFs and they decide benchmark selection, portfolio construction and ETF replication methodology.
For portfolio managers, ETFs are now available that focus on bonds with a specified range of durations, international or corporate debt and different levels of credit risk. These can be useful tools to manage the overall risk-reward contribution of fixed income holdings to a broader investment strategy.
