Rampant inflation and central bank interest rate increases are dominating the short-term outlook in fixed income — but longer-term, structural forces are changing the way that investors implement and manage fixed income allocations.
Our new global study, surveying 700 institutional investors and investment decision makers, reveals how exchange traded funds (ETFs) are an increasingly vital tool in the evolving fixed income landscape.
Data recorded by the New York Stock Exchange (NYSE), the world’s largest exchange, shows that assets under management (AUM) in fixed income ETFs grew from $574 billion in 2017 to $1.28 trillion in 2021; the number of funds has also increased rapidly, from 278 to nearly 500 over the same time period.1
Our 2022 survey shows that the role of ETFs in asset allocation is expanding to non-core sectors. For example, 62% of investors who are increasing exposure to high-yield corporate credit over the next 12 months say it is likely they will use ETFs to do so, and 53% say the same for emerging-market debt.
We can see the increase in use, as compared to our 2021 fixed income survey, Preparing for the Big Shift.2 In it, we found that 50% of investors were making significant use of ETFs to construct their core allocations, such as government bonds and investment-grade credit, but only 27% were doing so in their non-core allocations. The increase from just over a year ago is remarkable.
Figure 2: Investors Are Turning to ETFs to Build Core and Satellite Allocations
For those fixed income sectors to which you are increasing allocations over the next 12 months, how likely is it that you will use ETFs to build your exposure?
This trend is more pronounced among the largest institutions in the survey: 68% of those with AUM over $10 billion are likely to use ETFs to build new exposures to high-yield corporate credit, while 88% are likely to do so within emerging-market debt.
Survey findings indicate that investors are increasingly turning to ETFs, even in less efficient sectors (see Figure 2). One driver for this is that some investors appear to be coupling broad beta exposures with more specialist active strategies in these sectors. For instance, among survey respondents who plan to increase high-yield allocations, 44% will use a mix of index and active strategies; 47% will do so for emerging-market debt allocations.
It is not just index ETFs that are attracting greater interest in fixed income, however. Net flows into actively managed bond ETFs last year were the largest on record, according to EPFR data.3
More frequent — in some cases, daily — holdings disclosure, combined with greater liquidity than that provided by active mutual funds, could prove increasingly attractive for investors seeking efficient ways to rebalance their portfolios while retaining the benefits of active strategies.
“I think in high-volatility markets, you need to have more active management. And when you see things in the ETF prospectus that allow an actively managed ETF to really respond to volatility and sudden, large changes in the market, that should help with performance.”
— A fixed income manager at a US asset owner
Our survey results suggest that asset owners who already manage part of their fixed income portfolio in-house, or are in the process of internalizing it, may be driving active ETF adoption — particularly in Asia Pacific and Europe.
Fixed income markets saw significant volatility in the first half of 2022. With inflation climbing to 40-year highs in the US,4 the US Federal Reserve (Fed) and other central banks shifted to tighter monetary policies and implemented rate hikes.
Given this environment, our survey found a significant number of investors were planning to, or had already, shortened the duration of their portfolios.
The wide range of bond ETFs available to investors and ease of access the funds provide make it easy for investors to adjust duration in a targeted way.
A fund manager at a UK-headquartered wealth management company says his firm has been shortening the duration of its funds over the past 18 months:
“We have a very long preferred list of funds that enables us to make sector and duration plays — whether it’s ultra-shorts, 1‒3 year, 0‒5 year, or 10-year, we’ve got a vehicle at all of those different points to help us rebalance,” he says:
“With ETFs, you can be very targeted in your fixed income via passive strategies. It used to be the case that you got stuck with all maturities in a broad-based exposure. Now, there’s a vehicle for pretty much any duration you’re looking for.”
In response to the pressures of the previous low interest rate environment, many institutional investors had increased allocations to non-liquid sources of income, such as private credit.
AUM in private debt is forecast to reach US $2.69 trillion by 2026, overtaking real estate, according to alternatives data provider Preqin.5 This has reached a point where increasing portfolio liquidity is a top concern across all global survey participants.
Investors in our survey have been largely funding their privately placed allocations from liquid sources such as public fixed income and cash over the past three years (see Figure 6).
However, while the increase in private allocations may have improved investors’ yield and income profiles, it offers much less liquidity compared to a combination of more conventional fixed income, cash, and equities.
Investors in our survey are deploying a range of strategies to manage the increased liquidity risk associated with larger private credit exposure, including the use of fixed income ETFs.
“There are ETFs in the marketplace that have a higher yielding profile as well as the liquidity to act as a funding pool, or that can be paired with an allocation to private credit.”
—Bill Ahmuty, Head of SPDR ETF Fixed Income Group at State Street Global Advisors.
For pension funds in particular, it is essential to assess the implications of any rebalancing between public fixed income and private credit in the context of the scheme’s total liquidity requirements. ETF allocations can help schemes ensure they have the flexibility to meet short-term pension liabilities while seeking to maximize long-term returns.
A fixed income manager at a US asset owner says enhanced liquidity is one of the key benefits of using ETFs as portfolio building blocks:
“ETFs can be a great vehicle if you want to allocate to a certain sector. They’re great for liquidity, they’re easy to use and you’re not going to get hit on transaction costs as that’s straightforward to monitor,” he says. “But if you’re trying to generate alpha, then you also have to include some active strategies as you can’t just rely on being overweight in the right sector.”
The Global Financial Crisis brought about an extended period of historically low interest rates, which lasted more than a decade and pushed investors to improve efficiencies within fixed income portfolios.
This remains a priority today: 46% of our survey respondents said their organizations are under a lot of pressure to make more efficient use of the fee budgets within their fixed income allocations.
This pressure has led some asset owners to build in-house investment teams instead of relying predominantly on external managers. Our survey found that, among asset owners facing pressure to be more efficient in fixed income, 46% are planning to bring some part of their portfolio management in-house over the next 12 months, compared with 31% of those not experiencing the same pressure over fees.
The move toward internalization varies significantly across regions. In Asia Pacific, 64% of asset owners plan to bring part of their fixed income portfolio in-house over the next 12 months, versus 45% in Europe and just 8% in North America.
The size of the organization factors into this decision too: 64% of the largest asset owners surveyed ($10 billion+ in AUM) are bringing part of the portfolio in-house, compared with 34% for those with less than $3 billion in AUM.
As they take decisions to move money in-house, asset owners will need to think about efficient ways to build fixed income exposures with the resources they have at their disposal. Our survey found that those asset owners moving fixed income in-house over the next 12 months expect ETFs to be an important tool for building their exposure.
ETFs can enable investors to implement their allocation models without requiring large internal teams to manage them:
“If you don't have the resources, but you need exposure to that asset class, an ETF is the way to go. You're going to have someone who's an expert that's managing it, but you don't need all the different systems internally to run the portfolio. It's easy to scale up and, depending on the ETF, you'll have diversification as well.”
— A fixed income manager at a US asset owner.
Investors are under increasing pressure — from a risk, performance, and regulatory perspective — to ensure their fixed income portfolios take ESG issues into account.
Our survey found that integrating ESG considerations is the top priority for asset managers, wealth managers, and corporate pension funds to address through their fixed income allocations over the next 12 months.
There is some variance by geography in the survey, with 44% of North American respondents citing ESG integration as a top priority, versus 38% in Europe, and 36% in APAC. We believe this may be an indication that North America respondents are in the early stages of ESG integration, developing policy frameworks, and are more likely to make ESG a priority over the next 12 months, while European respondents have already done more in terms of ESG integration.
When it comes to incorporating ESG, the top priority for pension funds (35%) and asset managers (47%) over the next 12 months is to ensure all fixed income strategies meet the ESG threshold criteria set out in their policy frameworks. Respondents from endowments and foundations (based in North America) are more likely to be focused on creating these policies as a first step.
Investors are starting to think about how they can achieve more targeted ESG objectives in fixed income portfolios too. For instance, Paris alignment has become the most favored approach to ESG integration, with 46% of survey respondents looking to benchmark portfolios against Paris-aligned benchmarks. Science-based transition targets (34%) and ESG tilting (34%) — which involves incorporating ESG risks and opportunities into traditional financial analysis using a weighting scheme — are also favored approaches.
Notably, we see that as investors pursue their ESG objectives over the next 12 months, ETFs are viewed as important tools, particularly for pension funds and asset managers.
For investors seeking to bring ESG standards in fixed income portfolios up to levels set within their policy frameworks, ESG ETFs can provide building blocks to replicate existing asset allocation models while maintaining a similar risk-return profile for the portfolio. Index ETFs can be a useful tool to support more specific ESG goals, too. For example, where investors are committing to align with the goals of the Paris Agreement, ETFs can help to maintain diversification while applying a rules-based approach to re-weight issuers according to different emissions metrics.
“The transparency element of index ETFs is a real advantage. Implementing ESG scores and/or climate targets is complex, and so having an index that guarantees, by its construct, that it will meet specific objectives of ESG score improvement, or year-on-year CO2 emission reductions, can be valuable to investors committing to such a trajectory.”
— Antoine Lesne, Head of SPDR ETFs EMEA Strategy and Research at State Street Global Advisors
The fixed income landscape is changing as investors rethink traditional approaches to building balanced portfolios, ESG considerations gain greater prominence, and product innovation creates new routes for implementing strategies.
ETFs are an important part of this transition. The number of funds available and assets under management in index fixed income ETFs have grown over the past few years — and more recently in active ETFs too — providing investors with a wider range of tools to meet their portfolio objectives.
Our survey finds that increasing numbers of institutional investors are using ETFs to allocate efficiently to sectors, incorporate active management, and balance the liquidity profiles of portfolios.
Reflecting on the trends shaping the future of fixed income, we believe the utility of ETFs will continue to grow.
1 ETFs Rising in the Turbulence, NYSE, March 2022.
2 Fixed Income: Preparing for the Big Shift, State Street Global Advisors, July 2021.
3 EPFR, December 31, 2021.
4 US Bureau of Labor Statistics, July 2022.
5 2022 Preqin Global Private Debt Report.
In partnership with FT Longitude, a Financial Times company. This survey was conducted in May of 2022 via an online survey instrument (n=700) and telephone interviews (n=5). Respondents were limited to senior leaders and senior portfolio managers who are directly involved in fixed income portfolio construction and investment decisions at pension funds, wealth managers, asset managers, endowments, foundations and sovereign wealth funds.
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Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
International Government bonds and corporate bonds generally have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns.
Investing in high yield fixed income securities, otherwise known as “junk bonds”, is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations.
The returns on a portfolio of securities which exclude companies that do not meet the portfolio’s specified ESG criteria may trail the returns on a portfolio of securities which include such companies. A portfolio’s ESG criteria may result in the portfolio investing in industry sectors or securities which underperform the market as a whole.