Forces Fueling Demand For Bond ETFs

This has been a phenomenal year for fixed income ETF asset growth.

Bonds may not be nearly as exciting as the big-tech glitterati, but they’ve certainly—and rather quietly—stolen the show when it comes to attracting investor dollars this year. 

Consider the numbers: In the first three quarters of 2020, U.S.-listed ETFs gathered $318 billion in fresh net assets. Of that pie, fixed income ETFs took in almost half of all inflows, or $150 billion. They also outpaced net creations in equity ETFs by almost two-to-one. That’s practically unheard of in the world of U.S.-listed ETFs.

By the beginning of the fourth quarter, four bond ETFs sat among 2020’s 10 biggest ETF creations. Together, these funds tell this year’s bond story in a nutshell: Demand has focused on two parts of the market—corporate bond ETFs and classic aggregate broad funds—courtesy of the Federal Reserve one way or another.

Fed & Front-Runners Drive Flows
The Federal Reserve’s first foray into corporate bond ETF buying has been widely discussed. The year of a global pandemic saw central bankers across the globe resorting to whatever tools they had at their disposal to stabilize and bring calm to markets. Among those tools were about $8 billion in bond ETF purchases through the Fed’s Secondary Market Corporate Credit Facility between May and August.

The Fed itself isn’t responsible for the massive buying we’ve seen in bond ETFs this year. What’s $8 billion in the face of inflows totaling $150 billion and counting? But the Fed did help drive that demand, as investors rushed to front-run the Fed, and/or to follow its lead. The surge in bond ETF creations began in earnest right after the Fed announced its plans to buy bonds, before those government purchases actually started, and continued strongly through the summer and fall.

The iShares iBoxx USD Investment Grade Corporate Bond ETF (LQD) led the pack, with net inflows totaling $16.4 billion in just nine months. About $2.5 billion of that came from Fed purchases. In all, that’s asset growth of roughly 30% for this ETF in the first three quarters of 2020, pushing LQD total assets well above $55 billion.

Year to date, LQD delivered 7.3% in returns, neck-and-neck with the SPDR S&P 500 ETF Trust (SPY). The fund, which is a portfolio of more than 2,300 high quality corporate bonds, is also shelling out a 30-day yield of just over 2%, with effective duration of about 9 1/2 years (as of early October). For context, the Treasury-focused iShares 7-10 Year Treasury Bond ETF (IEF) is yielding 0.4% for a portfolio with effective duration of nearly eight years.

Another big corporate ETF gainer found among the year’s top creations is the Vanguard Intermediate-Term Corporate Bond ETF (VCIT), which picked up about $11.5 billion in that same period, nearly $1.5 billion coming from the Fed—that’s also a 30% add to its total assets.

High Yield Saw High Inflows
As a group, corporate bond ETFs took in roughly half of all net new assets flowing into U.S. fixed income funds in the first three quarters of the year. That list also reaches down the credit spectrum—high yield bond ETFs have also benefited from the Fed effect.

The iShares iBoxx USD High Yield Corporate Bond ETF (HYG) picked up more than $300 million in Fed money. Between January and the end of September, HYG saw net inflows total about $7 billion, making it too one of the year’s most popular bond funds.

Demand for such risky fare is impressive in a year when corporate solvency has been a concern, given the number of companies and industries battling the impact of shutdowns and supply chain disruptions due to the pandemic. Many have offered little to no future guidance in earnings. Risk abounds in this segment.

But a steady Fed hand—even if light in nominal terms relative to the massive asset haul these ETFs have seen—has proven quite the support for investor nerves, and the fuel for investor appetite. Credit risk seems relative when a backstop buyer of such caliber is in the picture.

More Than The Fed At Play
The year of the pandemic and all its uncertainty and turmoil highlighted the attributes of fixed income ETFs themselves.

They offer traditional risk diversification in an unpredictable market; income, albeit compressed in the face of low rates for longer; perceived safety, because downside losses are much more painful than upside gains are rewarding; and this year even stronger performance, as many fixed income ETFs delivered positive returns. (Bond prices and yields move in opposite directions)

Go-To Tool
Bond ETFs have been gaining ground rapidly in recent years, as investors both institutional and retail increasingly turn to these vehicles for cash management, liquidity, ease of access and trading, tax benefits, and for transparency in a bond market traditionally known for opacity.

Over a year ago, State Street Global Advisors cleverly coined the drivers of growth in bond ETF adoption the “4 C factors”: cost, choice, client need and comfort. Twelve months later, its research is proving true. Put simply:

• Investors have been flocking to lower-cost vehicles such as ETFs.
• Investors have chosen bond ETFs as choices have grown—a short 15 years ago, there were only six bond ETFs on the market. Today there are more than 400 fixed income ETFs.
• Investors have increasingly turned to bond ETFs, because need for income is growing as the population ages.
• Investors have become increasingly comfortable with bond ETFs as they are battle-tested in various market environments over the years.

In 2019, U.S. fixed income ETF inflows exceeded net creations in U.S. equity ETFs for the first time. In 2020, we’ve seen an acceleration of this trend driving demand for bond ETFs. Today U.S.-listed fixed income ETFs—U.S. and foreign bonds—command just over $1 trillion in combined assets, putting State Street’s $1.7 trillion-by-2022 well within sight.

Consider that many in this industry still see fixed income ETFs as a frontier. A lot of what’s-next ETF product innovation is expected to come in this asset class, and much in the form of active management.

Active Management Shining
In 2020, one the most popular bond ETFs is also vying for the No. 1 spot in the ranking of most-in-demand active ETFs:  the JPMorgan Ultra-Short Income ETF (JPST).

JPST, which has effective duration of less than one year, picked up $4.3 billion in net new money in the first three quarters of the year, bringing its total asset base to $14.5 billion only three years after it launched.

Like many of its peers, JPST is widely used as a cash management tool, something that has had big appeal this year, as investors look to keep cash on hand given the market’s wild turns. JPST is also a broad mix of bonds that deliver both capital preservation and income.

The SPDR Bloomberg Barclays 1-3 Month T-Bill ETF (BIL) fulfills a similar role, but with the added value of perceived risk-free Treasuries, and saw equally strong demand from investors focusing on shorter-term debt.

What’s Missing From This Picture?
Notably absent from the this year’s list of top fixed income gainers is longer-dated Treasury funds like the iShares 20+ Year Treasury Bond ETF (TLT) and IEF. TLT, the largest long-dated Treasury ETF, with $19 billion in total assets, faced big redemptions in the January-September window, bleeding $2.2 billion in assets. IEF, by comparison, was barely net positive, with inflows of about $400 million in the period.

There are plenty of factors casting a shadow on the perceived risk-free asset of choice for bond investors. The Fed is a buyer of Treasuries too—about $80 billion a month—but it’s not buying Treasury ETFs as much as it is corporates.

The strong bid under the market helped push prices higher and yields lower. The 30-year Treasury yields dropped nearly 40% in the first three quarters of the year; 10-year yields slumped some 60% in nine months. ETF investors may have trimmed exposure to longer-dated Treasuries, seeing little room for rates to go lower from here. If prices are near a top, and yields around record lows, why not trim back? 

Rock & A Hard Place
As a segment, Treasuries have been caught between good-for-prices Fed support and loose monetary policies, and bad-for-prices ample supply in the form of massive new issuance aimed at funding government efforts to handle a pandemic.

There’s also the concern that inflation will return, and the pace of economic recovery post-pandemic still looks very uncertain. A U.S. presidential election in November is another wrinkle, not only rattling markets, but one that could ultimately lead to policy changes down the line.

Treasuries may be seen as risk-free assets, but they aren’t immune to volatility, especially when rates are this low.