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Fixed income ETF adoption accelerated in 2022 as markets entered a new regime of greater macro-led market volatility while underlying bond market liquidity deteriorated
Following the yield surge in 2022, we believe investors must re-design their portfolios to reflect the role fixed income can play yet again in offering income
As multi-asset investors rebuild their portfolios into 2023, they can benefit from the breadth and granularity of indexed exposures, while the flexibility of ETFs can help navigate volatile markets
Rising inflation, rate hikes and geopolitical turmoil led to a volatile 2022. As global central banks embarked on an aggressive tightening cycle to curb inflation, bond yields and spreads rose to multi-year highs while underlying bond market liquidity deteriorated.
Against the backdrop of this new regime of greater macro volatility, the adoption of fixed income ETFs has continued, as investors use them for access, liquidity and managing risks in their bond portfolios.
BlackRock predicts global fixed income ETF AUM will reach $5trn globally by 2030¹, powered by changes in portfolio construction, with investors using them to generate active returns and create highly customised portfolios. Fixed income ETFs are modernising the bond market itself by driving electronification, algorithmic bond pricing and portfolio-oriented trading.
Last year was one of the most challenging 12 months for investors across asset classes. The $34bn inflows² into UCITS fixed income ETFs by the end of 2022 were characterised by a flight to quality, with government bonds and investment grade (IG) credit in favour. As market sentiment turned in Q4, investors used ETFs to add risk in portfolios, by allocating to IG and moderately to high yield (HY) credit, and lengthening duration.
Underlying bond market liquidity has been challenged for years, driven in part by the reduction in dealer corporate bond inventory levels since the Global Financial Crisis (GFC), combined with central bank intervention. In 2022, higher costs of funding for corporates led to reductions in new bond issuance – often considered as an important source of liquidity for investors.
Challenging liquidity in bond markets supported the shift towards alternative liquidity pools and trading strategies, such as index products including ETFs, and portfolio trades. ETFs have become an integral trading tool for fixed income investors.
Trading volumes across euro-denominated IG and HY credit ETFs rose 33% versus 2021³ while underlying bond volumes were flat. While ETF bid/ask spreads widened during periods of market volatility in line with elevated costs to trade, they continued to provide savings relative to comparable baskets of bonds.
As the ETF market continues to develop, the future scope of these products will see a more diversified investor base and further utilisation of ETFs as long and short instruments. Demand to borrow UCITS fixed income ETFs has grown, while volumes traded in options on UCITS fixed income ETFs more than doubled in 2022, with investors using these derivatives for volatility strategies, yield enhancement and downside risk management.
Looking into 2023 and beyond, we believe multi-asset investors will have to re-design their asset allocation to reflect the role of bonds as a source of income. Following the surge in yields, the case for high quality fixed income has brightened, particularly in the shorter end of the curve, while long-end bonds look more challenged.
As investors re-build their fixed income portfolios, the breadth and granularity of indexed exposures available can enable them to navigate new investment challenges. With higher market volatility likely to be a permanent feature of this new regime, flexibility within portfolios will be important. Against this backdrop, we believe fixed income ETFs will play an even greater role in the way investors access fixed income markets in the future.
Vasiliki Pachatouridi is head of iShares fixed income product strategy EMEA and Natacha Blackman is a fixed income product strategist for iShares in EMEA at BlackRock
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full magazine, click here.
¹ Source: BlackRock, “All systems go: Bond ETFs and the path to $5 trillion,” May 2022 ² Source: BlackRock, GBI ³ Source: BlackRock, TRAX, as at 30 September 2022
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