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Are ETFs an effective way to invest in fixed income?

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10/07/2012
As the commodities market takes the rap for an extremely uncertain time in the market - fears sparked off of the on-going Euro debt crisis and increasing worries over the global economic outlook, investors are keener than ever to seek out investments that generate stable and steady income streams.
Are ETFs an effective way to invest in fixed income?

Exchange traded products have seen an unprecedented level of demand over the past few months.

Inflows into ETPs, which mainly offer exposure to baskets of equities, bonds or commodities, attracted net assets of more than $100bn in the first half of this year – making it the highest amount since the industry emerged in the late 1980s, according to BlackRock’s ETP Landscape team. Currently the global ETP industry stands at $1.68tn.

Increasingly, investors are demanding exposure to income-producing assets, with fixed-income ETPs being the main contributor to inflows rising to $1.5bn, a 16% increase from this same period 2011.

Further, some 54% of fund managers have said that they are set to increase their exposure to ETPs and ETFs over the next three years, with a quarter anticipating an increase of 10% or more.

Gold ETPs in particular benefitted from the increase in inflows as investors cushion themselves from central banks’ recent decision to take steps to boost growth by loosening monetary policy.

Gold ETPs gathered $2.2bn in new assets, as an increasing number of investors hedge against economic turbulence with a more traditional gold outlook.

The Bank of England has just announced more quantitative easing to the tune of £50bn, in a bid to get the economy to grow, but this likely to hit UK savers and pension pots particularly hard.

Worries over inflation and a lack of adequate stimulus have helped investors become more risk-averse. The European Central Bank has similarly lowered its rates from 1% to 0.75%, the Eurozone’s lowest rate reduction yet, welcome relief to the in-debted, not so much for the savers.

Stephan Cohen, head of iShares Investment insights said: “Demand for bonds has increased greatly, driven by the need to de-risk and de-leverage portfolios, which has led many investors to increase their allocations to bonds and away from equities.”

“Monetary policy has created a situation where yields are very low, particularly for government securities, and investors relying on fixed income to generate the stable and steady income streams of the past are facing new challenges.”

 

Fixed income can no longer be considered a regular asset class – with new types of issuer emerging every day and increasing in size and structure. According to J.P. Morgan, issuance over emerging market corporates in US dollars has increased dramatically over the past decade – from $10bn in 2000 to $188bn last year.

Companies across the rating spectrum are also using the capital markets to raise funds – where before they would have turned to bank funding, they are now choosing to issue bonds instead.

Cohen continued: “This has created a situation where the divergence of returns between different fixed income asset classes has widened, making asset allocation, or being in the right place at the right time, a key driver of returns. Looking at Bloomberg data, since 2007 there has been a 20% to 40% difference in return between the best and worst performing fixed income sector in any given year.”

“Investors are analysing the markets in a more granular fashion, whether they are using fixed income, returns or both – and are allocating between bonds as they might have done with equities.”

Recent investor trend is to diversify holdings and make sure that the risk is spread out between the structures of the fund – in an effort to secure new sources of income. According to iShares Insights, UK investors are looking beyond the gilt market and considering other sovereigns and different types of corporate debt.

Cohen added: “High yield has been a particular beneficiary of this trend, providing investors who are comfortable with the credit risk they are taking on with a way to boost income. However, small and medium sized investors will find it much more difficult to access bond markets compared with equity markets.”

“In the first instance, fixed income markets are much larger than equity markets by capitalisation, with security-specific analysis less readily available, making it more demanding to evaluate opportunities.”

In the fixed income space, ETFs can offer investors a way to express their views and implement asset allocation decisions efficiently and precisely.

With no minimum subscription, it is possible to use ETFs to add exposure to an area of the market, such as emerging market corporate bonds, in a more cost-efficient and diversified way than buying individual bonds, which can add up on every transaction.

ETFs can be cost-effective investments, but you still have to weigh the related costs of an ETF against similar investments like indexes and mutual funds. Some ETFs are close-ended and therefore carry extra management fees.

Likewise, if you are actively trading ETFs make sure to include commissions in your cost calculations.

 

Dodd Kittsley, global head of ETP research for BlackRock said: “During times of economic uncertainty and increased market volatility, the efficiencies, precision and flexibility that ETPs may offer tends to resonate with investors.”

But Kittsley advised that as with any investment, investors need to conduct due diligence on the market they are investing in and the tools they are using to access it. For ETFs, one of the crucial first steps is to analyse the index on which the fund is built, and be comfortable with how it is constructed.

Researching your ETF and all of its holdings will also give you’re a firmer understanding of what kind of investment it is you are making. Just as you would scrutinise any stock before you buy, you are advised to research all the assets in the ETF.

If there is any equity that could possibly hinder the overall performance of your ETF, it may be wise to stay away from that particular fund.

Kittsley also urges investors to check to see who is managing the assets. The expertise of the fund manager can make a big difference on your returns. Alongside this, investors need to consider the liquidity of the investment.

Trading considerations and spreads can have a similarly significant impact on the success of your investment. The length of your investment horizon will also be a major factor in the success of your returns.

Another consideration is the way in ETFs are set up which could mean that they never mature.

Mona Shah, assistant fund manager of the Rathbone Enhanced Growth portfolio, said: “Coupons are reinvested at cash rates, and at month-end, are reinvested into the main index. Unlike the underlying bonds, ETFs have no maturity date, so when individual issues mature, the principal is immediately reinvested. This means most bond ETFs never “mature” and investors are subject to on-going interest-rate risk.”

 

Shah also points out that bond ETFs are generally more complex than equity ETFs, largely due to the fluctuating liquidity environment.

According to investment specialists Morningstar, the most important thing to consider before buying an ETF is the country of issue. If an ETF was issued in the US or France, investors may have to pay more tax on that investment than they otherwise would if they had bought the ETF in the UK.

Specifically the French and the Americans have tax regimes that enforce withholding tax, which often tax ETF dividends at a very high rate. Dividends from ETFs domiciled in France can be subject to a 30% tax deduction at source, which is not always fully reclaimable. Dividends paid by American-based ETFs can be subject to a withholding tax of 30%. This withholding tax can take a big chuck out of any investment gains.

For novice investors, ETFs that tracks a broader market is largely considered safer than any specific asset class. Using a brokerage that charges a monthly fee can also eat into your investment, so check carefully what the small print is.

According to Morningstar, investors need to be wary of the fact that not all ETFs are created equal, as the brokerage that you choose to use and their fees can leave you wondering why the same fund is getting higher returns than what you are getting back.

But generally, experts have no major concerns over the safety of ETFs – provided that they are physically backed, that they are run by one of the big issuers such as iShares or Deutsche Bank and that all parties concerned are domiciled either here in the UK or in another stable jurisdiction such as across the pond in the US.

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