ETFs And The Thorny Rehabilitation Of Fixed Income

When I was asked to chair a session on fixed income at this year’s Inside ETFs Europe conference, I was naturally apprehensive. Right now, government and corporate bonds have seldom seemed more volatile, with a possible rate rise from the Fed starting to spook investors of all stripes. No-one is quite sure when the tipping point for bond markets will come. There have already been rehearsals, but who knows when to expect the main event?

Throughout the conference I asked: “Why on earth would anyone have skin in this game right now?” But I was not alone. Rob Arnott, founder of Research Affiliates, said as much during a lively and engaging speech for an invited audience the night before my session. Speaking at an industry dinner on day two of the conference, Arnott said low yields have forced investors to look for alternative asset classes, saying mainstream bonds were “no way” to get decent fixed income nowadays. A stark comparison of starting yields in April 1985 and March 2015 – 6.1 per cent and 1.8 per cent – was all the proof that Arnott needed to back up his assertion.

He said: “The classic 60/40 distribution between equities and bonds in portfolios no longer holds. Falling inflation has meant that investors have to broaden their horizons beyond stocks and bonds and focus on markets that can hedge inflation risks. That means considering emerging market bonds, which have a positive correlation with developed world inflation.”

How Will Rates Affect The Markets?

The obvious question is: how much will rising interest rates hammer the market? David Thomson, chief investment officer at VWM Wealth and an attendee at my session, said there is an argument that the new normal for interest rates is now very low, at least compared to past standards, so the fall in fixed interest may not be too drastic; however, Thomson is not wholly convinced.

“Fixed interest had already done well as inflation was brought under control, and it then got a further leg-up as investors sought safety in the credit crunch,” he told me. “If that were not enough, it got a further push from quantitative easing and changes to regulations, forcing many institutions to buy. Consequently we believe there may be a 1994- type scenario as interest rates start to rise.”

Ben Kumar, investment manager at 7IM, said many investors are tempted to think the bull market still has a way to run, given that 10-year yields on government bonds in Japan [JGBs] dipped below 2 per cent in 1997 and have remained there ever since.

But he added: “It helps to remember that it is only with the benefit of hindsight that JGB’s seem to have had a golden era. Any spike up in the last 20 years was greeted with cries that the great bond bull market was over – and many investors saw themselves proved wrong time and time again, both on yield rises and yield falls.”

Turning To ETFs

The ongoing distortion created by quantitative easing has therefore achieved its “main aim” of forcing investors into risker assets, said Thomson. But can other investment vehicles, namely ETFs, persuade the fixed income sceptics to think again?

Gavin Haynes, managing director of Whitechurch Securities, agreed that investors “needed to take a long-term perspective and not be consumed by short-term market movements”.

Meanwhile, other advisers I spoke to at the conference in Amsterdam praised the lower costs of ETFs in making the market accessible for their clients. Fixed income ETFs are now a force to be reckoned with, but traditional weighting by market capitalisation – essentially ranking those with the most debt top of the index – is under fire. Rob Arnott's rather candid assessment was that this strategy is “definitionally sick”.

He added: “Why would you want market capped weighting in this space? When it comes to lending to governments, it is not in proportion to debt appetite but the debt service capacity of borrowers.”

Liquidity Questions

Mr Kumar flagged up liquidity as another cause for concern. “Bonds are traded off-exchange for the most part, especially in crises and in large size. As such, a bout of bond volatility may see niche ETF providers finding that they cannot redeem at reasonable levels.”

Indeed, even my knowledgeable panel of experts was reluctant to comment on how fresh political turmoil in Greece and questions about an EU referendum would play out for those niche ETF providers. “You let them off the hook too easily!” said one attendee, who clearly wanted me to pay homage to Jeremy Paxman. But the truth is that there was already plenty to chew over during my panel discussion, and throughout the conference, not least the thorny question of whether ETFs will ultimately help or hinder the rehabilitation of fixed income.

Iona Bain is a journalist, radio broadcaster and founder of Youngmoneyblog.co.uk, and reguarly appears in the media such as Channel 4 News