Morningstar: Bond ETFs Face Major Index Coverage Gaps

Bond exchange-traded funds face fundamental challenges that create opportunities for active management, according to a Morningstar study, The Bond Market as Fertile Ground for Active Management, that examines structural inefficiencies across fixed-income markets.

The research reveals that bond ETFs, which have grown in popularity as substitutes for individual bonds, encounter limitations that don't exist in equity markets. According to the report, bond index coverage is incomplete across major sectors, with only 80% of agency mortgage-backed securities covered by indexes and just 60% to 70% of commercial mortgage-backed securities included in benchmarks.

"Index-tracking ETFs appeal to a broader investor base, including retail investors, intermediaries, and institutions," according to the report. However, these funds "almost universally use sampling techniques to focus on their most liquid components" to avoid trading difficulties.

The findings suggest that while bond ETFs have improved market efficiency in liquid segments, structural market challenges create persistent opportunities for skilled active managers to exploit pricing inefficiencies that passive strategies cannot address.

Index Coverage Leaves Major Gaps

According to the study, approximately one-third of asset-backed securities lack index coverage. More concerning for ETF investors, entire sectors—worth over $1.3 trillion in gross issuance since 2010—have no widely available indexes or passive investment options, including collateralized loan obligations and nonagency housing debt.

The report found that concentrated bond ownership compounds these challenges. Morningstar's analysis of 350,000 bonds showed 57% were owned by only one asset management firm, while just 23% were held by more than three managers. This concentration limits trading activity and price discovery.

Trading Frequency Creates Headwinds for Bond ETFs

Bond ETF efficiency also suffers from infrequent trading patterns, according to the research. Of 35,000 corporate bonds studied, fewer than half traded at least once every three days, with more than 50% trading at most once every 19 days.

The study notes that while innovations like credit default swap baskets and ETF trading have fostered efficiency "in some segments of the market, inefficiency still lingers." The research found that investors often view the landscape as "bifurcated between the largest, most liquid bonds that respond most quickly and easily to market events, and those outside that arena that trade much less often."

According to Morningstar data, active bond managers outperformed benchmarks in 59% of rolling three-year periods, compared to just 17.6% for active equity managers versus stock benchmarks.