Fixed-maturity sterling-denominated corporate bond ETFs are a potentially huge development in the market if asset managers can circumvent the liquidity constraints of the space.
Fixed-maturity ETFs have been one of the most innovative product developments for the European market over the past year following BlackRock’s decision to bring its iBonds range across the pond in August 2023.
They allow investors to access a basket of bonds with a specific maturity date while benefitting from the diversification, transparency and liquidity benefits of ETFs.
Invesco is the latest player to enter the space after launching five target-maturity US dollar-denominated corporate bond ETFs in May.
The US giant follows DWS and Amundi which are also looking to compete with BlackRock in an increasingly crowded market.
So far, ETF issuers have focused on US dollar and euro-denominated corporates, euro government bonds, Italian BTPs, German bunds and US Treasuries, however, sterling-denominated corporates are yet to be wrapped by providers.
The key challenge for ETF issuers lies around liquidity. Sterling fixed income is a far smaller pool of securities versus the US dollar and euro-denominated corporate bond markets which creates challenges when looking to offer a liquid ETF solution.
Terry McGivern, senior research analyst at AJ Bell, said it would be a challenge to create a basket of fixed-maturity bonds within an ETF simply due to the size of the market.
He pointed to the Bloomberg Sterling Corporate Bond index which tracks approximately 950 securities, however, this does not account for specific maturities.
“When accounting for ratings, liquidity or minimum outstanding, it will end up with tight buckets each year with which to build an ETF from,” McGivern told ETF Stream. “Given diversification is one of the main attractions of fixed-maturity ETFs, giving this up would be a concern.
“While on the surface 20-30 securities may be better than holding a bond directly, I do not pay a management fee on direct holdings so investors need to consider whether there is an advantage.”
Paul Syms, head of EMEA ETF fixed income and commodity product management at Invesco, which recently launched its fixed-maturity US corporates ETF range, said the nuances of the sterling corporate bond market make launching fixed-maturity ETFs a tougher prospect.
He added the firm would look to create a solution if client demand is strong, however, cautioned the narrowness of the market.
One solution for sterling bonds, he suggested, is creating a fixed-maturity ETF that includes bonds across multiple years.
“The starting point for us was US dollar-denominated corporate bonds because liquidity is important as soon as you start carving an index into single maturities,” Syms said.
Despite the challenges, McGivern said any further innovation in the space would allow fund selectors to be “more surgical” with their portfolio construction.
“If it can be solved and the index is broad enough, allowing it to be bucketed up, maintaining diversification, credit rating and liquidity, then I would be very welcoming of product in the space,” he added. “Having access to fixed-maturity UK corporate bond ETFs, would allow us to be a lot more surgical in how we allocate to bonds under our asset allocation.”
Sterling hedged?
Given the liquidity constraints of the sterling bond market, one option for ETF issuers would be to launch sterling-hedged share classes of current target-maturity US corporate ETFs.
“An alternative solution would be sterling-hedged share classes of fixed-maturity US corporate bond ETFs,” McGivern said. “Investors would end up with similar return profile and maintain diversification and liquidity, but would have to be cognisant of additional hedging costs and the differences in rate environment.”
His views were echoed by Oliver Faizallah, head of fixed income research at Charles Stanley, who told ETF Stream a sterling-hedged fixed-maturity ETF would be a most welcome innovation to fund selectors’ suite.
“A fixed maturity investment grade corporate bond ETF would have great appeal to investors who are unable to access the direct bond market,” he added.
“While these products are becoming more available, a sterling-hedge share class for UK-based investors would be a great addition to the product suite in 2024.”
