As the new year begins, markets remain turbulent, as concerns about consistently high inflation have given way to worry that central banks’ efforts to curb inflation may lead to a recession.
But, while investors and advisors negotiate this difficult climate, certain exchange-traded fund (ETF) strategies have outperformed, particularly those linked to higher-quality fixed-income assets.
Despite the fact that last year’s bond market was the worst in decades, the global bond ETF industry had a stellar year.
According to BlackRock Global Business Intelligence statistics, global industry-wide bond as of year-end 2022.
Considering this momentum, the global bond ETF market is now expected to surpass $2 trillion in assets under management (AUM) this year and $5 trillion by the end of the decade, according to iShares, which manages more than 1,250 ETFs internationally.
Fixed-Income ETF
Bond ETFs, which are structured as funds that invest in various fixed-income securities or Treasuries, offer investors a low-cost way to pursue income, diversify their portfolio, and strive to limit risk.
In a recent report, iShares, which introduced the first bond ETFs in the United States in July 2002 (LQD, SHY, IEF, and TLT), stated that bond ETFs have become fundamental to fixed-income investing over the last two decades because they connect fragmented fixed income markets with transparent and liquid on-exchange trading.
With interest rates rising as a result of central banks’ monetary tightening efforts, investors are turning to these ETFs as an appealing alternative to traditional fixed-income instruments, as rising interest rates can lead to a reduction in bond values.
“The future looks bright for the rise of bond ETFs since they let all types of investors take on the thorniest problems in fixed income. In fact, we believe that the challenges associated with high inflation and rising interest rates will attract more first-time ETF investors while also prompting existing investors to find new ways to use these versatile investment tools,” stated BlackRock President Rob Kapito and Global Head of ETF and Index Investments Salim Ramji in the report titled “All Systems Go.“
Growth Factors
While it took the bond ETF market 17 years to reach $1 trillion in AUM, the path to $2 trillion is expected to be much shorter, thanks to four major growth drivers that iShares believes will swiftly boost bond ETF adoption.
1. 60/40 Portfolio Building Blocks
Bond ETFs can be extremely beneficial building blocks in a classic 60/40 portfolio of equities and bonds, helping to construct the “40” element – the 40% of the portfolio that is allocated to bonds.
“Adding or deleting exposures through bond ETFs — for example, modulating between high yield and government bonds — can help investors develop evolved portfolios by calibrating objectives such as income, capital preservation, or equity risk diversification,” according to iShares.
According to iShares’ talks with investors, more investors are understanding the benefits of combining these ETFs with active strategies to better satisfy investment objectives and minimize unnecessary risks.
“We have witnessed a growing number of wealthy investors wanting to diversify risk assets at the portfolio level using basic bond barbell strategies comprising of wide, index bond ETFs and actively managed fixed income mutual funds that aim non-correlated returns,” iShares says.
2. Techniques for Finding Active Returns
Because of the product’s transparency, access, liquidity, and portfolio efficiency, institutional investors have been among the fastest-growing adopters of bond ETFs since the outbreak of the worldwide pandemic.
Specifically, iShares discovered that active managers who previously only used individual bonds in their portfolios are now embracing these ETFs as instruments for liquidity management, portfolio efficiency, and possible portfolio-level alpha production.
“While many managers have consistently used bond ETFs to rapidly dial up or down tactical risk exposures, some are starting to realize that these ETFs can also represent ‘betas’ (long-term, core market exposures) and ’tilts’ (a persistent allocation to a specific return exposure, such as high yield) that can replace a cumbersome number of individual bonds in portfolios,” iShares reported.
3. Bond Market Modernization Catalysts
Bond ETFs have helped to push electronification, algorithmic bond pricing, and portfolio-oriented trading over the last two decades, reshaping the structure of fixed-income markets.
These ETFs have helped improve transparency and liquidity in underlying bond markets as electronic trading and algorithmic pricing of individual bonds have advanced and according to iShares, will play an even larger role in how investors access fixed-income markets in the future.
4. More Specific Sources of Possible Returns
Many of the newest ETFs have provided more accurate fixed-income exposures in recent years, allowing investors to design increasingly personalized portfolios, hedge risks, and seize opportunities.
These ETFs subdivide asset classes into more granular exposures across credit kinds, sectors, durations, sustainability profiles, and other risk variables.
“The next generation of ETF innovation is just getting started,” according to iShares, which anticipates the next generation of more active bond ETFs to reach $1 trillion in AUM by 2030, up from around $200 billion now.
“It will emphasize the integration of advanced tactics such as sustainability, factors, and an ever-increasing number of defined objectives.”
Consider Buying Bond ETFs
With the current state of the markets, investors and advisors have a chance to add these ETFs to their portfolios in order to reduce risk.
Bond ETFs from iShares can help protect against increasing interest rates and supplement or replace existing fixed-income holdings.
For example, the iShares 1-5 Year Investment Grade Corporate Bond ETF (IGSB), which invests in short-term US investment grade corporate bonds, currently has a lower duration than the S&P 500.
According to iShares, IGSB had an effective duration of 2.61 years as of January 31, 2023, compared to the iShares Broad USD Investment Grade Corporate Bond ETF (USIG), which had an effective length of 7.01 years.
Furthermore, the iShares® iBonds® ETF suite provides investors and advisors with a collection of bond funds that hold a diverse portfolio of bonds with similar maturities, ideal for a conservative or aggressive strategy.
The iBonds ETF suite includes U.S. Treasury bonds, municipal bonds, and both investment grade and high-yield fixed income.
Similarly to classic bond laddering schemes, each ETF in this suite is designed to produce recurring interest payments and distribute a final dividend in its specified maturity year. Yet, the funds’ distinctive structure is meant to allow investors simply establish bond ladders with only a handful of funds.
“We expect that evolved portfolios will increasingly contain bond ETFs as crucial aspects for balancing risks and opportunities while simultaneously enhancing liquidity and cutting costs. Furthermore, we expect that institutional investors will continue to use this strong technology, and bond ETF innovation will bring the market more accurate tools for portfolio design and risk management,” iShares said.
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