What fixed income ETFs can bring to your portfolio

All this is increasing the pressure on fixed income investors to find new ways to protect their portfolios and boost yields.

With all these challenges to deal with, fixed income exchange-traded funds are being used by a growing number of institutional investors, including pension funds, for a range of applications.

As the market for fixed income ETFs has increased in both size and liquidity, product innovation means virtually all bond asset classes are now available.

Since their launch in the US in 2002, fixed income ETFs have become an increasingly important part of bond markets. Global assets today stand at $475bn (£310bn), and the growth of fixed income ETFs is accelerating in the wake of the 2008 financial crisis.

Although bond issuance has reached record levels, new regulations have led to lower dealer inventories and driven down trading volumes and liquidity for individual bonds.

This, in turn, has led to fixed income ETFs increasingly being used alongside other instruments, such as cash bonds and index derivatives.

Range of applications

The uses of ETFs by pension schemes range from liquidity and transition management to portfolio construction, tactical asset allocation and as an exposure tool in hard-to-access markets.

ETFs can help investors navigate volatile markets by offering additional liquidity to that of the underlying bonds, as well as real-time price information.

This can be helpful for a manager building a new diversified fixed income portfolio, or efficiently putting to work a significant inflow of cash into an existing portfolio.

ETFs can be used to gain immediate access to fixed income markets during the construction phase of a portfolio.

Meanwhile, the portfolio manager can carry out the required single-name bond trades, moving out of the ETF over time as the liquidity in the underlying bond market allows.

ETFs can offer solutions for transition management and dealing with legacy portfolios. A pension fund might want to redeem the holdings of an active fixed income manager in order to run the monies in-house or transfer to another manager.

Rather than redeeming wholly in cash and having to return to the market to purchase new individual bonds – taking time and incurring transaction costs – an ETF provider could evaluate the underlying bond portfolio.

If a good match is identified with the constituents of a specific fixed income ETF, the provider can receive the bonds in return for issuing units of the ETF.

This means the scheme manager maintains the desired beta exposure to the fixed income market while conducting their search for a new active manager or building up their in-house capabilities.

Redeeming holdings from an active manager via ETFs can provide a more manageable portfolio with far fewer line items, a clearer risk profile and a potentially better match for a target asset allocation.

Diversification

With the yield challenge ever present in an environment of historically low interest rates, investors are increasingly having to consider less familiar sectors of fixed income, such as emerging market debt.

While investors need to recognise the risks, gaining exposure has the potential to add yield compared with developed market bonds.

The inclusion of uncorrelated assets may reduce volatility and can increase return potential for the overall portfolio.

Sourcing a diversified portfolio of these bonds can be challenging, however. Local currency exposure may increase returns but it does add volatility.

ETFs can enable investors to access hard-to-reach areas of the global bond market through well-diversified and liquid vehicles.

Brett Olson is head of fixed income iShares EMEA at BlackRock