Bonds are thriving within the ETF wrapper. By year-end 2016, ETF bond assets reached nearly $450 billion. While that may seem like a small slice of the overall pie, bond ETFs haven’t been around as long as their equity counterparts. The first U.S.-listed equity ETF was issued in January 1993; it wasn’t until July 2002 that bonds entered the ETF scene.
Nearly 15 years later, bond ETFs are driving growth for the industry. Over the last five years, bond assets have increased by roughly 19.7%, compared to 13.3% growth in other categories. In 2016, the pace of bond ETF growth was more than double the rest of the industry.
So what has contributed to the success of bond ETFs? The answer can be separated into two components:
Bond funds offer investors significant advantages over a portfolio of individual securities. They allow investors to dramatically increase their levels of diversification. The advantages go beyond enabling investors to diversify credit risk across a few issuers; bond funds allow them to allocate across multiple bond sectors. There is huge disparity between a laddered portfolio of 10 investment-grade corporate bonds and a portfolio diversified across Treasuries, municipals, mortgages, investment-grade credit, high-yield credit, international sovereigns, and emerging market bonds.
Liquidity is also an important factor. Bond funds allow investors to access the aforementioned exposures much more cheaply than by buying individual issues from a broker. Even in the relatively liquid U.S. investment-grade bond market, an investor could easily spend more than a year’s worth of interest income crossing the bid-ask spread.
Another benefit of bond funds is targeted interest-rate exposure. With a laddered bond portfolio, the exposure to interest rates is falling until a new bond is purchased for the portfolio. With a bond fund, the portfolio of hundreds, or even thousands, of names can be easily adjusted to maintain a targeted exposure. Some investors believe a laddered portfolio of individual bonds can protect them against rising rates. The thinking goes: If rates rise (and the value of the bond falls), the bond can simply be held to maturity and the par value can still be received. While that is technically accurate, this fails to consider all of the lost income from choosing to retain a portfolio of lower-yielding bonds. Regardless of the time to maturity, or the scale of the interest rate move, the result is the same.
While ETFs and mutual funds share in the advantages above, the ETF is simply the superior product wrapper. CLS discusses the benefits of ETFs frequently, including in the Quarterly Reference Guide. The benefits include:
Bond ETFs are excellent tools for investors and make up an integral part of a balanced portfolio. For all of the reasons mentioned, CLS thinks bond ETFs will continue this steep growth trajectory.