Bond ETFs—Not Dead Yet!

June 21, 2011

Last week, Paul Amery wrote a eulogy for bond ETFs. But Paul’s missing the forest for the trees.

There’s an old story about a group of blind men all trying to describe an elephant. Depending on which man you asked, he describes a pillar, a plowshare or a paintbrush. Although Paul and I are looking at the same ETF marketplace, I’m seeing a very different animal than he is.

As Paul mentioned, a number factors, such as the end of the U.S. government’s second round of quantitative easing (QE2) and the continued turmoil related to European sovereign debt crisis, continue to put negative pressure on bond markets. But just because there’s a bear’s case doesn’t mean there are no signs of life.

As a Bloomberg article mentioned yesterday, May saw a greater amount of money deposited than loaned out with U.S. banks. Banks simply don’t have the appetite for lending that they used to. They also don’t have much incentive when the money they borrow through deposits and Fed funds costs virtually nothing.

It’s much safer and more profitable to loan the money to the federal government through the purchase of Treasurys. As long as it remains profitable for banks to continue buying high-grade fixed-income instruments instead of making loans, yields will remain low as the demand for Treasurys remains steady.

Unfortunately, the catalyst for change remains relatively low. News related to the economic recovery continues to seesaw between good, bad and ugly, with markets quick to react to the slightest change. The “risk off” trade continues to be a flight to quality, with investors piling into Treasurys at the first sign of trouble.

On the other end, investors have more options than ever to take on risk within the fixed-income world. Currently, there are 163 fixed-income ETFs trading in the U.S., including levered products. Of those, 31 have launched this year. Fourteen of these funds had a non-U.S. focus, increasing an investor’s ability to get exposure to different segments of the bond universe. Six funds provided inverse exposure to bonds for those who wish to be bearish, while five funds provide levered exposure for those who are bullish.

 

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