FlexShares: The Rise Of Fixed Income ETFs

May 16, 2018

[This ETF Industry Perspective is sponsored by FlexShares.]

We believe the recent uncertainty and flight to safety, along with a surge in interest rates, has fueled inflows into fixed-income assets. High-grade corporate bonds, TIPS, municipals and even high-yield bonds all touted recent inflows, despite the proposed end of quantitative easing in the U.S. and increasing interest rates.

Today, with continued uncertainty upping market volatility measures, plus the potential for two federal interest rate hikes, we believe investors should understand exactly how best to approach fixed-income investing and why fixed-income ETFs continue to be one of the fastest-growing vehicles with which to do so.

Bonds Are Positioned To Grow
Fixed-income securities—generally bonds—have always been integral to the investment portfolios of institutional investors, retirees or near-retirees and those who are planning a large purchase in the midterm future. Given the “aging of America,” plus the fact that investors can anticipate longer retirements than ever before, we believe demand for fixed-income assets will continue to grow.

 

Flows Chart

(For a larger view, click on the image above)

 

Bonds are historically unmatched for their ability to generate a reliable income stream, mitigate overall portfolio risk and generally protect investors from market volatility. But:

  • Smart and cost-efficient investing in individual bonds can require a great deal of money and time in order to address diversification and risk considerations.
  • Risk must be analyzed using several complex measures, such as credit, yield to maturity, and default and duration risk, making fixed-income securities much more difficult to judge than more-straightforward equities.
  • Interest rate risk must be considered (as interest rates rise, bond prices usually fall; as rates drop, bond prices typically rise).
  • Last but not least, regulatory changes have negatively impacted the market, increasing liquidity risk, impacting price volatility and discouraging certain players from bidding and offering securities on a daily basis.

The Rise Of Fixed-Income ETFs
Fixed-income ETFs are a relative newcomer, having first launched in 2002, approximately 10 years after equity ETFs. Despite the fact that the global bond market dwarfs the global equity market, they remain a small part of the total ETF market. Despite recent volatility in the debt markets, according to Morningstar, as of 12/31/2017, 2017 inflows into U.S.-listed taxable bond ETFs totaled over $120 billion.

As with all ETFs, fixed-income ETFs offer potential advantages when it comes to expenses, taxes, transparency of holdings and intraday tradability. But beyond these basics, we believe fixed-income ETFs offer many advantages over individual bonds and even over fixed-income mutual funds:

  • Maturity: Rather than a fixed date at which investors are paid back, ETFs maintain a weighted average of the maturities of all the bonds in the portfolio. As individual bonds mature, additional bonds are bought with the goal of maintaining a constant maturity.
  • Market Liquidity: Single bond issues may trade daily or as infrequently as once a month. Like all ETFs, the funds themselves trade on an exchange and can be bought or sold during market hours.
  • Monthly Income: While most bonds pay out interest every six months, bond ETFs generally pay interest monthly, giving investors a potentially greater source of regular income. Interest payments vary with the averages based on the underlying bonds in the portfolio.
  • Price Transparency: ETF prices are published on the exchange, and the price of the basket of holdings is updated every 15 seconds during the trading day.
  • Diversification: ETFs potentially enable investors to own hundreds of bonds in a single security at a purchase price that could be substantially lower than investing in those same bonds individually.

 

Expanded Liquidity In Volatile Markets
We believe the regulatory and rate environment is forcing investors to analyze their fixed-income holdings and evaluate the potential higher costs for quality, maturity and yield of individual bonds, and therefore creating a desire to develop a better understanding of the trade-offs between safety of principal, income and access to funds in managing overall liquidity.

There are several potential reasons fixed-income ETFs can offer liquidity when the bond market as a whole may not be as responsive. One is ETFs’ open-ended structure and their creation/redemption mechanism, wherein shares can be added or subtracted at any time. We believe that process, along with liquidity in the secondary market, allows ETFs to trade at or near what is perceived as fair value with little-to-no market impact.

Another potential aspect of measuring an ETF’s liquidity is its premium/discount data, which demonstrates whether and when the ETF may have been priced higher or lower than its actual net asset value (NAV), or end-of-day trading price at close of market. When markets are calm, market price and NAV often can remain relatively close. In volatile market periods, however, the two may diverge to varying degrees, often due to multiple reasons including a widening of the spread of the underlying securities or even buying and selling pressures of the underlying securities within the portfolio.

Interest Rates & Fixed Income Investing
We believe the potential for rising interest rates is a wake-up call for fixed-income investors. Today, investors must add to their shopping lists exposure and risk transparency as well as control over impactful investment decisions.

But with proper understanding of interest rate dynamics and related market challenges, bond investors can develop scenarios to potentially reap enduring benefits. Learn more about scenario planning for interest rates.

 

IMPORTANT INFORMATION
Before investing, carefully consider the FlexShares investment objectives, risks, charges and expenses. This and other information is in the prospectus and a summary prospectus, copies of which may be obtained by visiting www.flexshares.com. Read the prospectus carefully before you invest. Foreside Fund Services, LLC, distributor.

An investment in FlexShares is subject to numerous risks, including possible loss of principal. Fund returns may not match the return of the respective indexes. The Funds are subject to the following principal risks: asset class; authorized participant; calculation methodology; concentration; corporate bond; counterparty, credit; debt extension; derivatives; financial sector; high portfolio turnover; income; inflation; interest rate/maturity; issuer; liquidity; management; market; market trading; mortgage-backed pass-through securities; non-diversification; non-U.S. issuer; passive investment; prepayment; securities lending; tracking error; U.S. government securities; U.S. issuer; and valuation risk. A full description of risks is in the prospectus.

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