Part 2: Fixed Income ETF’s
In this second article of the series “Deep dive into ETFs with Invesco” fixed income ETF’s are explored. A fixed income ETF is an investment tool that offers investors exposure to a wide range of debt instruments issued by governments, municipalities, corporations, or other entities. While fixed income ETF’s operate similar to equity ETF’s in many regards, differences arise when dealing with the fundamental characteristics of the underlying bonds. The differences between equities and fixed-income securities can be useful for investors and provide value to a well-diversified investment strategy.
Stocks versus bonds
Firstly, it is important to note how fixed income products (mainly bonds) differ from stocks. Stocks represent the ownership of a company and buying a share allows you to benefit from the company’s profits through dividends and capital appreciation. The upside of a stock is therefore theoretically unlimited. Bonds are debt instruments that pay regular coupon payments1 to investors for a predetermined period of time and return the face value2 of the bond at the date of maturity3. Bonds are generally regarded as safer investments due to a higher legal claim, periodic interest, preservation of capital and less volatility. They are furthermore traded OTC and generally in large sums.
As the returns on fixed income products are generally lower, more emphasis is put on transaction costs, tracking error4 and optimalisation by ETF managers. So, when discussing the purchase of fixed income ETF’s with clients these factors play a more important role relative to the equity ETF’s. Also, fundamental differences between stocks and bonds are included in the investment objectives of clients including the duration, creditworthiness, sector exposure and yield of the bonds. Factors such as the alfa or beta of the fund, which are very common topics for equity ETF’s, do not play a role in discussions for fixed income ETF’s.
To track the performance of indices using ETF’s, a variety of index replicating strategies can be apprehended. The two main categories that can be regarded are physical replication and synthetic replication. Invesco is one of the biggest players in synthetic replication and this topic will be extensively covered in the next article of the series. Physical replication is the most common way for an ETF to replicate an index and seeks to replicate an index’s performance by holding the same physical assets as the index. While this method is the most straightforward, it may face some drawbacks when the index consists of hundreds, or even thousands, of stocks or bonds. When the amount of assets becomes too large, the cost of physically replicating all constituents may outweigh the benefit of minimizing tracking error. In these cases, it may be beneficial to buy a selection of the index in a method called stratified sampling. An index is divided into subsets or strata, based on characteristics such as maturity, credit quality and sector exposure. For each stratum a subset of bonds is selected that best represents the index. Stratified sampling is applied to achieve the optimal combination of minimizing tracking error (TE) and transaction costs (TC). Stratified sampling is particularly useful for illiquid bonds as the additional transaction costs can quickly outweigh the reduction in tracking error.
Figure 1: Stratified sampling Figure 2: Transaction costs vs Tracking error
Illiquidity in the bond market
As fixed income ETF’s trade differently from their underlying constituents, it is worth considering how market information is incorporated in fixed income ETF’s. Bonds are traded OTC and in large quantities while fixed income ETF’s trade continuously on the exchange similar to stocks. Bond ETF’s can therefore in some instances function as a price-discovery tool. A prominent example of this was during the market crash in the beginning of 2020 when fixed income markets experienced enormous price pressure and illiquidity. At these times of market illiquidity, the fixed income ETF’s provided a solution. As the fixed income ETF’s, contrary to the underlying bonds, traded continuously on the exchange, transactions could continue in the liquid secondary market without having to buy and sell the underlying bonds in the illiquid primary market. This allowed the fixed income ETF’s to function as a price-discovery tool in the sense that they were better suited to reflect the price of the underlying bonds than the bonds themselves. The performance of the bond ETF’s during the COVID-crisis was thoroughly tested through an unprecedented stress test on the liquidity of fixed income markets. The fixed income ETF’s stood the test and were able to provide liquidity in times of bond market illiquidity.
Current events in the fixed income market
Observing current events in the fixed income market, one of the most notable trends is related to the interest rate policy of the central banks. The rapid increases in global interest rates have led to inverted yield curves in the fixed income markets. A yield curve represents the current interest rate environment and the market’s expectation regarding future economic conditions. Figure 3 represents the yield curve of July 2022. It shows a “normal” yield curve with higher yields for longer-term bonds than shorter-term bonds. As future market conditions are uncertain, investors demand to be compensated with higher yields. The current yield curve is shown in Figure 4. Due to the high interest rates the yield curve has become inverted, meaning that shorter-term bonds have a higher yield than longer-term bonds. Short-term interest rates are generally determined by the central banks while long-term interest rates are decided by the market. When there is a large discrepancy between the two you can get an inverted yield curve.
Investors are switching a lot between maturities trying to anticipate the macro-economic conditions and future interest rates. These predictions can however vary very strongly per investor.
Figure 3: Yield curve July 2022
Figure 4: Yield curve July 2023
With a market characterized by unusually high global interest rates, fixed income markets have become turbulent. Fixed income ETF’s have proved to be a price-discovery tool in the past by offering additional liquidity in illiquid markets.
In the last article of the series synthetic ETF’s are discussed. With Invesco being one of the world’s leaders in the field of synthetic ETF’s, this will prove to be an interesting article. If you are interested in working in this industry, check out the vacancies of Invesco by clicking on the button below! Moreover, the Financial Career Platform has many other vacancies within the Asset Management industry and beyond. Besides that, FSR will organize the Asset Management Tour in the beginning of November where you can have the opportunity to visit various asset managers. Stay tuned!
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The information provided in the article is intended to be used and must be used for informational purposes only. Our content is not intended as, and shall not be understood or construed as, financial advice.