While bonds have long been an I-beam of fixed income portfolios for investors, fixed income ETFs are modernizing the bond market and providing a far more nimble, versatile tool for institutional investors to manage risk and volatility in portfolios. They allow investors to use the two key advantages inherent in ETFs – the ability to trade on exchange, and all-in-one access to a variety of securities chosen to target specific exposures – to create more focused strategies and react more quickly to opportunities and risks. We asked Stephen Laipply, Managing Director, Head of U.S. iShares Fixed Income Strategy at BlackRock, to explain why fixed income ETFs have become vital in fixed income strategies.
In general, how are institutional investors viewing the role of bonds in portfolios given this low-rate environment?
Stephen Laipply: From an income perspective, with yields being so low, investors have naturally shifted their positioning. For example, some investors are allocating to higher yielding bonds seeking to generate more income. However, the traditional roles that bonds play in portfolios – as a source of income and diversification – both remain. Why? Because as low as rates are, they could still go lower. And if we encounter a pronounced risk-off environment, bonds will still play a valuable role in diversification.
How have fixed income ETFs changed the way fixed income portfolios are constructed now?
Fixed income ETFs are a powerful innovation in the fixed income market. While they’ve been around for many years, they've become much more central to portfolio construction in the past five years for a number of reasons.
One is liquidity. In essence, fixed income ETFs are portfolios of bonds that trade on exchange – and that simple attribute can be powerful from a liquidity standpoint. It gives investors more transparency into pricing and can allow for trades with narrower bid-ask spreads. As a result, fixed income ETFs have become more attractive for institutional investors.
Overall cost is another reason. Fees for ETFs have come down, and we’ve heard in conversations with institutional clients that using fixed income ETFs for a core position in the portfolio can be cheaper over the long-term than rebalancing to maintain positions in individual bonds.
What are the advantages to using fixed income ETFs rather than selecting individual bonds?
Fixed income ETFs give investors the flexibility to build portfolios in a more efficient and precise way than relying solely on individual bonds. That’s because innovations in the past few years have resulted in fixed income ETFs that are far more specific and refined. Certainly, there are still broad, highly liquid products like aggregate fixed income ETFs; BlackRock has a fixed income ETF that’s more than $89 billion in size as of November 2, 2021 and tends to be quite liquid. But the specificity and granularity of fixed income ETFs have become greatly enhanced in recent years.
For example, you not only have credit ETFs, but within these ETFs there are different tiers of ratings and maturity cuts. They include investment grade options, such as ETFs that track the BBB segment of the market, high-yield options with ETFs that track the BB segment, and so on. And we’re likely to see further refinement from there. It’s just more cumbersome to create this level of granularity with individual bonds.
Can you give an example of how a portfolio might integrate fixed income ETFs and individual bonds?
In our view portfolio managers are constantly balancing elements of costs, liquidity, and efficient exposure in deciding what to own. As one example, you could have low-cost fixed income ETFs for certain betas and factors, as well as liquidity management – and then have higher-conviction positioning in individual bonds or derivatives for idiosyncratic risk. We see many investors already doing this. They now have a range of building blocks in their toolkits to create strategic, efficient portfolios.
Can fixed income ETFs help you seize potential alpha opportunities?
Absolutely. We saw this clearly during the market dislocations in the spring of 2020. Institutional investors using fixed income ETFs in their fixed income strategies were more able to access the opportunities created by those dislocations.
As you’ll recall, as the market fell, it was hard to sell individual bonds. And when the market rallied, it became hard to buy. So the liquidity challenge cut both ways. Institutional investors using fixed income ETFs were able to manage their liquidity on the way down, and then leg back into that exposure when risk sentiment changed. They were able to move very quickly and, as a result, capture a lot of upside. It was difficult for investors trading the underlying bonds to react as quickly and effectively, simply because it was so hard to move that risk.
While moving quickly to capture alpha opportunities is a great advantage to the asset manager community, longer-term asset owners – such as pension plans and insurance companies – have also embraced fixed income ETFs.
Let’s talk about ESG. What impact can fixed income ETFs have on holistic portfolio construction?
We're starting to see a lot of interest in fixed income ETFs for ESG and sustainable fixed income. One area is purpose-driven investing, of course, in which investors deliberately allocate to these exposures for ESG objectives. However, we're also seeing interest from more investors who don’t hold ESG as a primary goal but recognize that ESG funds can be attractive from a risk/return standpoint.
What can fixed income ETFs offer institutional investors in terms of international opportunities?
Fixed income ETFs have been proven to be quite useful for international exposure, especially in emerging markets. There are many large, emerging-market fixed income ETFs available now that investors are using for liquidity and exposure management. The role of these ETFs becomes more pronounced in volatile markets. We’ve really seen fixed income ETFs shine in instances when a risk-off market is impacting emerging markets, because they allow investors to manage that exposure in real time which is difficult to do in the underlying equities.
What about exposure to alternative assets?
We don't yet have fixed income ETFs on alternative assets like, say, private credit. ETFs still tend to track more liquid, publicly tradable markets. But we are starting to see investors use ETFs in the context of alternatives to increase liquidity. When you have a portfolio of alternative assets, those exposures can be less liquid. So we're starting to see investors use sleeves of fixed income ETFs to help balance out that liquidity profile. As an example, if investors need to source liquidity quickly – such as during a volatile market – they can use the ETF sleeve to help manage that need rather than trying to unwind those high conviction, long-term private credit allocations.
How can BlackRock help institutional investors improve or implement a fixed income ETF strategy?
Using our advanced portfolio analysis technology, our Portfolio Consulting team can help investors understand the risks embedded in their portfolios and create strategies using fixed income ETFs to represent that risk more efficiently and in a more liquid fashion. Rather than just looking at a list of bonds, this analysis allows investors to really understand the moving parts of the portfolio in terms of betas, tilts, factors, liquidity profile and other critical aspects. That’s a powerful advantage in enabling them to retool their portfolios in the most efficient way possible. And of course, BlackRock’s scale and technology footprint is a key differentiator for us. We can help institutional investors embrace fixed income ETFs as an innovative technology that can help them accomplish their investment objectives, whether that's alpha or risk management.
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Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.
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