ETFs can provide particularly compelling benefits compared to purchasing securities directly. Discover key reasons to consider adding fixed income ETFs to your portfolio.
Although exchange-traded funds (ETFs) are hugely popular among investors looking for equity market exposure, they aren’t always the first port of call when it comes to bond allocations.
However, fixed income ETFs offer several benefits for anyone looking to add diversified and liquid bond exposure to their investment portfolio - with a level of simplicity and transparency that isn’t possible by investing in global bond markets directly.
To find out why investors are starting to take notice, we need to take a look at how fixed income ETFs work. Here are three key reasons to consider adding fixed income ETFs to your portfolio.
1. Fixed income ETFs standardise and simplify bond investing
Investing directly in the bond market can be challenging. One reason is that bonds do not trade on an exchange-instead, buyers and sellers are required to negotiate over the counter (one on one) to agree a transaction price. In contrast, bond ETFs, like equity ETFs, trade on exchange and provide transparent pricing. While the stock exchange that the ETF is listed on is open, investors can buy and sell shares just like they would for a single stock.
The ETF creation and redemption mechanism, through which authorised participants (APs) can exchange ETF shares for the ETF’s underlying basket of securities, ensures that bond ETF prices remain close to “fair value” at all times. For example, if an ETF is trading above “fair value”, the AP is incentivised to create new shares for the market by delivering the basket of bonds to the ETF issuer-therefore increasing the supply of ETF shares and driving the ETF price back towards “fair value”.
The reverse is true if the ETF price is below its “fair value”. For example, if many investors want to sell an ETF, its share price might fall below its basket’s value. Here’s how the process would work to reduce shares in those instances. Market maker buys ETF shares, usually at a discount to basket value. Shares are redeemed by sending them through an Authorized Participant (AP) to the ETF issuer, in exchange for the underlying securities. Market maker sells those securities, usually for more than they paid for ETF shares.
In this way, bond ETFs can act as a price discovery tool, helping investors see how the value of a basket of bond securities may be changing in reaction to market movements.
2. Fixed income ETFs provide an effective way to diversify and make strategic or tactical portfolio allocations
For the price of one unit, investors can get access to a well-diversified fixed income portfolio. Buying such a diversified basket of fixed income securities directly in the market would likely require a significant investment beyond the means of most investors.
Bond ETFs also allow asset allocation decisions to be implemented quickly and efficiently. As an example, an investor looking to lower the duration in the US government bond portion of their portfolio can implement their view quickly and efficiently, without the need to frequently reinvest the cash flows typically associated with this segment of the market.
Furthermore, investors can use ETFs to gain exposure to a wide range of bond markets, from emerging market debt (hard currency and local currency) to investment-grade bonds, through market-cap, strategic beta or active strategies.
3. Fixed income ETFs offer liquidity benefits compared to transacting directly in the underlying bond markets
Bonds in many mainstream indices often do not trade on a daily basis. In the investment grade corporate bond markets, trade frequency tends to be skewed towards those bonds with the largest issue sizes, with bonds with the largest issuance size trading on most days, while bonds with a smaller issuance often not trading at all.
While it is prudent to assume that the liquidity of an ETF may need to be derived from the liquidity of the underlying market, the ETF secondary market offers an additional liquidity venue through which to transact on an exchange or over the counter. In the case of large bond ETFs, buyers and sellers are often able to transact at lower bid-ask spreads than through the primary market.
Standardise and simplify your bond investments
In relatively illiquid markets, ETFs can provide particularly compelling benefits compared to purchasing securities directly. This is certainly the case in the global bond markets, where-as we’ve seen-investors face particular diversification, liquidity and pricing challenges.
Fixed income ETFs not only allow investors to trade their fixed income holdings on exchange throughout the day at a transparent price, just like a stock, subject to any fees intermediaries (e.g. a stockbroker) may apply". They can also provide a higher level of diversification with ease of access-giving investors the opportunity to standardise and simplify their bond investments.