Bonds are the cornerstone of many investment portfolios: Learn how to identify the right fixed income ETP.
Fixed income is an important component of most diversified portfolios, and fixed-income ETPs can be a great vehicle for accessing that exposure.
Like equity ETPs, fixed-income ETPs offer exposure to a basket of securities that, in this case, is a basket of bonds. Fixed-income ETPs target all corners of the market from speculative emerging markets debt to top-notch US government debt.
The process for picking a fixed-income ETP is similar to picking any other asset class. First, you’ll need to determine your targeted exposure—the type of bonds you’re interested in. Next, you’ll need to consider the credit ratings and interest-rate risk of the ETF’s underlying securities. (For specific information on each of these topics, see “Understanding Duration” or “Understanding Credit Quality.”)
Broadly speaking, fixed-income ETPs fall in three categories:
- Sovereign – ETPs targeting fixed-income securities issues by governments of sovereign nations; US Treasurys and UK gilts fall into this category
- Corporate – ETPs targeting fixed-income securities issued by corporations.
- Broad Market – ETPs that have exposure to both sovereign and corporate debt.
You’ll also need to choose the geographic exposure you want. Do you want to target US-issued securities? Or fixed-income securities issued in the UK or the eurozone? Or do you want to venture out into the emerging markets space? Conventional wisdom suggests there are growth opportunities in less-developed markets, but not without additional risks.
It’s also important to understand how the index a fixed-income ETP tracks, selects and weights its holdings. While most fixed-income indices tracked by LSE-listed ETPs are selected and weighted based on market value—total outstanding debt issuance—some are selected based on credit ratings, liquidity or currency denomination.
For those looking at the active space, PIMCO offers a handful of actively managed fixed-income products as well. Active managers need to be evaluated for their track record and likelihood of outperformance, so extra due diligence is required there.
Maturity, Yield And Interest-Rate Risk
Once you decide on a type of exposure, you need to decide on the maturity you’re targeting. Are you looking for bonds that live for 20 years? Or three months? The longer the average maturity, the more sensitive the ETP will likely be to interest-rate changes. Interest-rate risk covers the sensitivity of a bond’s price to any changes in interest rates. When rates go up, bond prices go down and vice versa. A bond’s sensitivity to changes in interest rates depends primarily on the bond’s coupon rate and its time to maturity. For example, if you’re holding bonds with 10+ year maturities, those bonds are likely to sell off harder if interest rates move up, compared with bonds maturing in the near future.
Normally, investors demand more yield from longer-maturity bonds in return for the added risks of lending for such a long period. As such, longer-maturity ETPs usually carry a higher yield.
(For specifics on this topic, see “Understanding Duration.”)
With exposure and maturity decided, you’ll need to determine the creditworthiness of the ETP’s underlying bonds. Are they rated investment grade by the major credit rating agencies, or are they rated below investment grade (high yield)?
The credit rating of a bond also intersects with the bond’s yield. Naturally, bond issuers with lower credit ratings (and higher probability of default) must offer higher interest rates on their debt to entice investors.
(For specifics on this topic, see “Understanding Credit Quality.”)
The majority of fixed-income ETPs traded in London use a physical replication strategy. These funds generally pay out interest payments from the underlying securities to shareholders, and many investors invest in fixed-income products specifically for income-generating purposes, counting on the periodic interest payments from those ETPs.
But ETPs don’t pay out interest every day—they hold the received income and make payments on a schedule: monthly, quarterly or even longer. It’s worth looking at those schedules if you’re counting on the income.
Some fixed-income indices—particularly broad ones, or ones targeting illiquid niches—can be difficult to fully replicate, so issuers implementing a physical replication strategy will often use a sampling (optimized) strategy to track the index.
For example, the iShares US Aggregate Bond UCITS ETF holds about 1,000 securities, but its underlying index, the Barclays US Aggregate Bond Index, consists more than 8,000 securities. At times, heavily optimized portfolios can lead to greater tracking error if the fund manager isn’t careful.
To circumvent these challenges, some ETPs employ a synthetic replication strategy. These products generally track “total return” indices, meaning dividends are continuously reinvested back into the index, and no income is distributed to investors.
Finally, currency fluctuations can significantly impact the ETP’s returns. Historically, we have seen significant routs in emerging market currencies that have seriously detracted from the returns on emerging market debt that is denominated in the local currency. This has exacerbated the negative returns in certain emerging market debt ETPs fully exposed to the local currencies. Moving forward, of course, there’s no saying whether currency routs will be confined to the emerging markets.