Bond ETFs: expressing a view

  • Investment Insight
  • 4 minute read

In the later stages of an economic cycle, many investors question whether buying bond ETFs is sensible. At such times, their argument goes, interest rates rise, inflation may spike as the economy overheats, and defaults increase as companies fail to meet their debt obligations. As each of these is generally bad for bonds, it pays to be selective when choosing bond ETFs.

Active bond funds have the opportunity to add value – Close Bond Income Portfolio Fund and Close Select Fixed Income Fund certainly do. But bond ETFs aren’t only about the broad market; our Close Tactical Select Passive (TSP) fund range offers optimised exposure to fixed income by fulfilling our Tactical Asset Allocation (TAA) and actively focusing both on specific investments and segments of the market.

Of yield curves, barbells and liquidity

In fixed income, our current TAA favours investment grade corporates and short duration, typically of 0-5 years’ maturity with some Gilts and Index Linked Gilts (Linkers) added for ballast and event-risk hedging. In December 2018, for example, Gilts rallied +2.4% and Linkers +2.5% respectively in GBP terms when equity markets tanked, but only after trailing for much of the year. Linkers, specifically, may alleviate some Brexit risk: a bad/no deal scenario may cause Sterling to weaken, inflation to rise and Linkers to rise. Roughly speaking, our ratio of short- to full-duration is 40/60, effectively being a barbell approach to expressing which segment of the yield curve we are more comfortable holding given our macro views.

There are still certain areas to which bond ETFs do not provide access. To fully express our TAA, for example, we have included the Close Bond Income Portfolio Fund within the TSP fund range, from a 3.2% allocation in Conservative to ~1.8% in Balanced and Growth. At zero cost, it is the only proprietary fund we own.

As the popularity of bond ETFs has increased, so has the focus on bond index methodologies. An interesting example is the L&G LOIM Global Corporate Bond Fundamental UCITS ETF. The underlying index tracked weighs each company’s bonds depending on their creditworthiness as determined by revenues and debts, and potentially assets, loans, earnings and cash flows. Each industry sector and geographical region’s importance to the economy is also taken into account. The weights are then adjusted to prioritise companies with higher liquidity and higher yields. This sifts out weaker bonds and should result in us having higher quality names without sacrificing too much performance. The fund is held in Conservative (3.3%), Balanced (1.4%) and Growth (1.5%).

Another criticism levelled at bond ETFs is that indiscriminate buying will eventually cause a liquidity crunch and painful losses if there is a stampede to get out. We disagree. In our opinion, there is no evidence to suggest that liquidity in ETFs will be worse, and spreads any wider, than in other open-ended bond funds during market stress. This is because an active bond ETF fund manager can discern what to trade, within their remit of sampling bonds according to their methodology, without being motivated by bond selection, and at times selling out at a loss in illiquid markets.

In extremis, theoretically, an ETF manager could gate a fund to protect investors, effectively making a temporary transition to an investment trust (close-ended fund) trading at a premium or discount to its NAV. We stress that this is an extremely remote possibility, which would be hugely unpopular, even if normal pricing and trading quickly resumed. Remember, though: this wouldn’t be about the illiquidity of the underlying investment (such as property which is tricky to sell), but rather the irrationality of the market (which would pass). Counter-intuitively, it is the indiscriminate buying of bonds captured within a very discriminating methodology, such as L&G’s above, which might end up helping investors to navigate challenging times.

Value added

Clients pay us to generate returns and protect their investments. As this economic cycle matures, we aim to do both through TAA and stock selection. Whether you prefer active, passive or active-passive approaches to fixed income, each can achieve a similar goal. Buying bond ETFs does not mean stepping blindly into the market and hoping for a market return.

 

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