A (re)balancing act: why are investors turning to ETFs for bond exposure?

In recent years, interest in fixed income ETFs among retail investors has risen rapidly as adoption by institutional investors accelerates.

Fixed income ETFs in Europe accounted for just 25% of the region’s ETF assets in January this year but captured more than 50% of flows in the month, the highest level since 2019.¹ In March, which followed a period of interest rate volatility, fixed income ETFs accounted for almost 45% of flows.

Ease of use and cost-effectiveness are two obvious reasons for the increase in interest. Fixed income ETFs give traders and investors a liquid way to express their bond-market outlooks or to position portfolios to meet liabilities or income needs.

A fixed income ETF comprises a basket of bonds that are packed together with the aim of tracking a specific index.

An investor who wants to replicate an index could, of course, seek to buy the individual components of the underlying. However, investing directly in the underlying bonds can be challenging and there are some important considerations.

Transaction costs and spreads

Rebalancing is used to adjust the weightings of the constituents in an index to reflect changes in the underlying market. This is typically done on a regular basis, such as monthly, quarterly or semi-annually. In order to keep a portfolio in line with the index, holdings must regularly be bought and sold to match changes in the index. The cost of rebalancing a portfolio includes transaction costs and bid/ask spreads.

The transaction cost (fees charged by brokers for exchange securities) varies depending on the size of the trade, the type of securities and market conditions. Typically, each rebalance necessitates a lot of small trades; the smaller the trade is, the more expensive execution is likely to be as a percentage of the transaction.

When investors buy or sell securities, there is also the bid/ask spread to consider. For less liquid securities or smaller-sized trades (less than $100,000), bid/ask spreads can be wider, which can increase the cost of rebalancing a portfolio.

Four reasons why investors may look to ETFs for bond exposure

Investors who want to replicate a fixed income index also have the option of buying an ETF – a product that was specifically designed to track the performance of an underlying index or benchmark. ETFs have several potential advantages for index replication purposes:

• Accessibility: Fixed income ETFs offer individual investors the ability to access the bond market without the high minimum investment requirements and transaction cost associated with purchasing individual bonds
• Liquidity: Bond ETFs can provide superior liquidity compared with their underlying bond markets. An ETF can be traded continuously during the day on- or off-exchange, and its liquidity is supported by multiple dealers. By contrast, individual bonds may be less liquid and may take longer to sell. Research² published earlier this year found about 30% of corporate bonds receive one-sided quotes with the bid side quoted less than the ask side, particularly during stressful periods. Fixed income securities, such as corporate bonds, are typically traded over the counter, where a lack of liquidity can occur for days at time, meaning less sophisticated participants, such as retail investors, have limited or no direct access to dealer quotes³
• Transparency: Fixed income ETFs provide transparency in terms of their holdings and performance, making it easier for investors to track their investment and understand the risks involved
• Cost-effectiveness: The ETF provider may be able to negotiate lower transaction costs than an individual investor could, due to economies of scale associated with managing a larger portfolio

In the second part of this blog, we’ll examine the creation and redemption mechanism that supports the liquidity of ETFs.

This discussion of ETFs is for illustrative purposes only. The above information does not constitute a recommendation to buy or sell any security.

1. Source: Bloomberg as at 31/03/2023

2. Source: https://business.unl.edu/academic-programs/departments/finance/about/seminar-series/documents/KumarVenkataraman.pdf

3. Source: https://www.sec.gov/spotlight/fixed-income-advisory-committee/survey-of-microstructure-of-fixed-income-market.pdf