Fixed income exchange traded funds (ETFs) combine the ease of stock trading with the diversification benefits of managed bond funds. We explore four key reasons why investors might consider fixed income ETFs as part of a well-balanced investment portfolio.
Holding core fixed income investments, such as investment-grade credit or government bonds, in a well-balanced portfolio can help you navigate challenging market environments. The benefit of owning a diverse range of investments is that when one asset class falls in value (e.g. equities), other asset classes (e.g. fixed income) might increase in value and help offset the loss. Bonds also exhibit a different pattern of returns, as they generally fluctuate less than equities. But even if correlations change and bonds start to behave like stocks for a short period, their lower volatility helps reduce any dips in valuation across the broader investment portfolio.
In the same way shareholders receive dividends, bond investors can also enjoy an income stream in the form of coupon payments. A predictable and regular cash flow, coupled with relative capital stability, mean that investors can manage their finances more effectively and comfortably meet spending needs – especially when compared to drawing income from assets that fluctuate more widely.
A wide variety of fixed income ETFs, ranging from index tracking, smart beta, and active, is now available, with new products regularly introduced to the market. Index fixed income ETFs are favoured by investors seeking diversified, low-cost, low-turnover exposure, and these funds often reference a well-established index. Index management skill is often reflected in the quality of the ETF, such as how closely it replicates the underlying benchmark
Meanwhile, active fixed income ETFs might be favoured by investors seeking alpha, downside risk management or some other specialised portfolio style. That said, pure alpha is difficult to achieve. Therefore, active investments work well for those with the resources to perform due diligence and monitoring to ensure the portfolio fulfils its role, doesn’t drift from the stated objectives, and has continuity in the portfolio management team.
ETFs enable investors to establish and liquidate very small or large positions readily. In smaller portfolios, ETFs provide diversification in a single trade, with the minimum size possibly as little as a single ETF share. This is compared to the larger minimums often required by mutual funds or direct investments. At the other end of the spectrum, larger portfolios may benefit from the flexibility of transacting either in cash or in kind. Meanwhile, for all investors, the ability to buy and sell ETFs on the stock exchange adds a layer of liquidity not available when investing directly in bonds or mutual funds. Trade volumes have been shown to increase during periods of market dislocation, meaning exposures change hands more readily when liquidity is needed the most.
ETFs are also seen as a preferred vehicle because of their high level of transparency. For most ETFs, information, including daily holdings, characteristics, NAV, and intraday pricing, is readily available to investors.
For all of the above reasons, investors have been increasingly turning to fixed income ETFs when building their investment portfolios. The growth and reach of the fixed income ETF market we have witnessed in recent years is likely to continue.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates rise, 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.