BOND ETF GROWTH WILL OUTPACE STOCK ETFs

We’re cheating a little here, because this prediction’s already come true. One only need look at net inflows into fixed-income funds in 2016 so far to see that bond ETFs are growing faster than their equity cousins.

As of the end of September 2016, investors had already poured $77.7 billion into U.S. and international bond ETFs, bringing total assets invested in the space to $393.2 billion.

That well outpaces net inflows into stock ETFs over the same period ($52.8 billion). It even swamps flows into fixed-income ETFs for the entire year prior ($61.1 billion).

Sure, bond funds still only represent 18% of the total ETF market. That’s nothing compared to equity ETF assets, which topped $1.62 trillion as of September’s end.

But investors are flocking to bond ETFs in record numbers.

2 Reasons For This Growth
We think that’ll continue for two reasons. First and foremost is investors’ simple, driving need for income—which has been hard to come by in the current environment.

Loose monetary policies by central banks worldwide have depressed yields to super-low, even negative levels. That leaves institutions and other investors hunting whatever income they can find, wherever they can find it.

Investors have been particularly drawn to corporate debt: As of Sept. 30, the $33.2 billion iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) was the fourth-fastest-growing ETF, with $7.19 billion in new flows year-to-date.

In addition, tougher regulations on financial institutions have squeezed liquidity in the secondary market, depleting inventories and spiking both costs and volatility.

In this, bond ETFs offer several advantages. The ETF wrapper makes it easy to purchase diverse bond types in quantity, or from more illiquid sectors, such as emerging market debt. In fact, ETFs are sometimes even more liquid than the sectors they cover, allowing investors to stay nimble in challenging markets. Plus, ETFs are often cheaper than active managers or mutual funds.

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“Fixed-income ETFs are becoming an institutionalized part of the investment process,” said Josh Penzner, managing director at BlackRock and head of iShares’ Fixed Income and Insurance Distribution. “In the past, the ETF was just a side note. But now it’s become core to how institutions manage their money.”

To an extent, market conditions favoring bond ETFs will likely persist into 2017. Most central banks are no closer to tightening their monetary policy—meaning rock-bottom yields will probably stick around for some time to come.

Rising U.S. interest rates, however, could dampen enthusiasm for bonds, specifically Treasury ETFs. The Fed has already hiked rates once, and has made noise about raising them again soon.

“There’s no getting around the math,” said Dave Nadig, director of ETFs at FactSet. “Higher rates are bad for bond prices.”

Still, if rates do rise, investors likely won’t abandon fixed income altogether, but rather push into fund flavors that can weather the change, such as interest-rate-hedged funds or floating-rate ETFs. They may also transition into shorter-duration ETFs, or into muni bonds or mortgage-backed securities.

“A significant bond market correction could create buying opportunities for yield-hungry investors who’ve been dabbling in everything from MLPs to smart-beta dividend strategies,” added Nadig.

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