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Separating fact from fiction in the rise of fixed income ETFs (Part 2)

Man in brown shoes having to decide between myth and fact
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This is a sponsored article from State Street Global Advisors.

Kheng-Siang Ng
Asia Pacific Head of Fixed Income
State Street Global Advisors

Exchange-traded funds (ETFs) are quickly expanding their role in providing institutional investors with access to fixed income. A new survey of institutional investors by Greenwich Associates1 reveals 24% already have a stake in Asian fixed income ETFs, making them the most popular passive fund option. Additionally, a further 22% are considering adding them to their portfolios, giving these funds the highest potential growth rate among all possible investment vehicles.

Despite their growing popularity, several misplaced concerns about fixed income ETFs persist. In this second article in a two-part series, we investigate the most pervasive concerns to separate fact from fiction. For part 1, please click here.

Misconception 4: Fixed income ETFs are exposed to riskier companies
One common misconception is that fixed income ETFs are overweight on the most indebted companies, leaving investors exposed to the riskiest firms. While this is an understandable concern, it is not true.

An ETF’s index construction inherently provides diversification benefits and often employs constituent capping to mitigate concentration risks.

In addition to the broad diversification afforded by indices, large issuers of debt are also companies with substantial asset bases and revenue profiles. This provides the ability and the capacity to pay and service the debt on the firm’s balance sheet. Focusing only on the amount of debt an issuer has in an index overlooks key variables.

Indices are rules-based and focus on diversification and liquidity to ensure investability. As a result, not all of an issuer’s debt is included in the index, which paints an incomplete picture of the firm’s overall indebtedness. For instance, an issuer can have short-term liabilities, debt financing secured in a subordinated form, or financing denominated in a different currency that do not qualify it for inclusion in an index.

In fact, companies with a higher level of debt do not necessarily always pose a greater risk than businesses with less debt, nor do they have a lesser capacity to pay. If this was the case, there would be a clear, linear relationship between debt issuance and credit ratings. However, credit rating agencies consider several factors beyond the debt level, including the capacity to service debt.

Misconception 5: There are too many bonds to make fixed income index investing efficient
While investors are increasingly noting the advantages of passive investing, some still believe it is not suitable for fixed income investing, simply because of the sheer number of bonds in an index.

However, the objective of an index investment manager is not to hold every single issue in the index, but rather to track an index’s return with minimal tracking error.

Sampling can be the most efficient technique for constructing portfolios, as many broad fixed income indices include a large number of securities but not all of those securities can be purchased. Coupled with potentially high transaction costs to access illiquid bonds, full replication is not always possible or practical.

With a sampling approach, an investment manager aims to replicate the key characteristics of the index’s duration, curve, and issuer credit exposure.

There are two main approaches to minimise tracking error: Top-down and bottom-up. The former approach seeks to align the common factors of the ETF to the index, while the latter approach is often used in markets such as high yield where there is usually greater price volatility.

Misconception 6: Fixed income ETFs are difficult to trade
Some of the key benefits attracting institutional investor attention to fixed income ETFs include liquidity, diversification, and lower costs. In addition to this, 44% of respondents in the Greenwich Associates survey cited ease of execution without complex due diligence processes as another main attraction of these investment vehicles. Complexity varies depending on the needs of the investor, but there are two straightforward ways to access fixed income ETFs: Through exchange liquidity, or over-the-counter (OTC) liquidity.

When considering whether to trade on exchange or OTC, it is important to consider the trade size. As you would expect, similar to single stock equities, larger trades that exceed average daily volumes should be handled with greater care by working with a broker-dealer or OTC market maker.

Investors also value ETFs for their transparency. ETF issuers typically publish daily pricing reports that include principal, interest, cash, and accrued interest/undistributed income, meaning that any investor is able to price the ETF.

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1State Street Global Advisors commissioned Greenwich Associates to conduct a global study of 151 institutional investors and 36 intermediary distributors from Asia Pacific, Europe, and the United States between October 2018 and March 2019.

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The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.

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