Choosing fixed income ETFs
Whether passively or actively managed, fixed income ETFs can be an alternative to traditional bonds.
What are fixed income ETFs?
First, an ETF is a fund that offers exposure to a basket of securities and can be bought and sold over an exchange, like the Toronto Stock Exchange (TSX). ETFs can passively track indices or be actively managed and can offer access to particular asset classes or sectors.
Fixed Income ETFs offer exposure to the debt marketplace and to multiple bond issuances. These ETFs have been a game-changer by allowing investors to access fixed income exposure through an exchange. Bonds are typically only available to institutional traders in over-the-counter (OTC) networks that are not accessible to most individual investors. Secondly, fixed income ETFs offer diversification through exposure to multiple bond issuances, reducing single issuance selection risks.
In 2022, Canada’s fixed income ETF marketplace represents approximately $87 billion of Canadian ETF assets under management (AUM). Like equities, the fixed income category is a broad universe, comprising dozens of sub-categorizations and debt instrument focuses, including treasuries, government, corporate, investment and sub-investment grades, as well as emerging themes and classes, like green bonds and Limited Recourse Capital Notes (LRCNs).
What to consider for Fixed Income ETF Exposure?
Many investors are often surprised to learn how much bigger the bond marketplace is compared to equity markets: for instance, in the U.S., on average, the market of investable bonds has been 79% larger than the stock market since 19951.
That difference starts to make more sense once you consider that while equity markets include corporations, debt markets also include institutions, governments and other organizations. Indeed, just like the strategy of selecting certain sectors using ETFs based on their outlook, investors can choose to do the same with bonds by selecting targeted exposure by country, sectors, asset-backing, as well investment grade.
Heading into 2022, investors determining how they want to allocate their fixed income investments might consider secular trends, like the impacts of climate change and global inflation, and regional trends, including aging demographics.
There are many different factors to consider but it’s important that investors take a long-view approach with fixed income investing. Whether you have the time to do so, is a different question and invites consideration about whether you should take an active or a passive approach to your fixed income ETF investing.
Passive Fixed Income or Active Fixed Income?
Selecting a passive approach
One of the ETF solutions that offer investors easy bond exposure are passive fixed income ETFs – that is, ETFs that track indices of bond issuances, without an active portfolio manager. These products can do a good job of bundling together multiple correlated bond issuances based on rating, sector or geography.
However, indexing (passive investing) is not a one-size-fits-all investment solution. When an asset class has less liquidity, indexing can become less efficient, even for large asset class like U.S. High Yield Corporate Bonds, Canadian Corporate Bonds or Canadian preferred shares.
Part of this disparity has to do with the nature of index construction in the fixed income category. Many of the large, fixed income benchmarks determine the weights in the index by the amount of outstanding debt. For equity indexing, weighting based on company size can be an indicator of company strength, but weighting a company based on its level of debt may not be a reliable way to rank issuance value in a fixed income index.
In addition, liquidity can be an issue. In parts of the fixed income market where there is less liquidity (such as high yield bonds or preferred shares), sourcing issuances can be more difficult — particularly in a market sell-off where buyers may not be readily available with sufficient capacity to take on bond inventory. On its face, fixed income index ETF investing may seem flawed, however many of these issues are structural within the underlying asset class itself.
Choosing active management ETFs
Active fixed-income ETFs are managed by experienced bond traders and portfolio managers. These professionals understand how to navigate the complexities of the fixed income marketplace, where to possibly access preferred bond issuances and how to potentially locate yield within the market landscape.
Active fixed-income ETFs do typically have higher management fees and can have higher transaction costs, which can impact return. Active also means that the ETF is based on the trading decisions of the manager, so it’s essential to look at track record to make an informed decision.
However, given the state of fixed income markets in 2022, an active manager could be the right choice in the search for yield in a low-rate environment.
The Search for Income and Yield in Low Rate Environments
For income-seeking or more conservative investors, fixed income ETFs are often sought to incorporate more conservative exposure in portfolios. For instance, in 2021, market dynamics spurred by COVID-19 stimulus and a low interest rate environment have diluted some of the value of traditional fixed income investing. This is particularly true in an inflationary environment, where the collective repayment of yield and principal might not significantly outpace inflation.
In this context, to find appreciable yield, some fixed income investors are opting for a tactical fixed income approach. It can be by selecting an active manager that can deliver it through an ETF’s mandate or by choosing to take on sub-investment grade and junk bonds (speculative-grade bond), ranging from emerging markets to some corporate issuances.
These strategies can be riskier than traditional government and investment grade bond investing but can potentially offer outsized yield opportunities, in excess of inflation and interest rates. For investors seeking to expand their fixed-income exposure but not wanting to miss out on potential equity market upside, this approach could be the right mix for today’s environment.
2022 Fixed Income Outlook
While the global markets experience since 2020 has proven anything but predictable under the zeitgeist of the COVID-19 pandemic, investors seeking to invest in fixed income using ETFs should keep these considerations in mind for the year ahead.
No matter what is on the horizon for fixed income markets in 2022, investors seeking to build out their fixed income exposure should consider the relative advantages of fixed income ETFs. Fixed income ETFs are market event-tested: in the height of the early COVID-19 related volatility in March 2020, fixed income ETFs remained liquid, even when compared to their underlying bond portfolios. Fixed income ETFs are a great innovation to the debt marketplace that is here to stay and will continue to be a significant benefit for investors in 2022 and beyond.
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