“What our analysis shows is that there is a time and a place for use of ETFs for portfolio managers in the fixed interest space,”

Fixed income investors be alert: the massive shift of money into passive equity investment strategies is about to hit the debt market, too, and with good reason.

Analysis by AMP Capital’s Multi Asset Group shows that fixed income exchange traded funds (ETFs) can be a cheaper option than derivatives in certain circumstances.

“Futures can be very expensive when they are consistently rolled over,” says AMP Capital Senior Portfolio Manager Fixed Income Sector Lydia Serafim. “In certain instances, ETFs can sometimes be more cost effective for portfolio managers.”

The figures are significant. Serafim told a recent Capital Insights Forum that when the cost and trading differences are combined, interest rate futures can be multiple times more expensive depending on both the market movements and time frames involved during the period of analysis.   

“The key is truly understanding all the costs involved, that is the hard part,” she says. “Many market participants would be surprised to realise that ETFs could be a viable option for hedging purposes.” 

Products such as derivatives, including futures and credit default swaps (CDSs), have traditionally been used by debt investors to either add or take off risk underlying investments in sovereign bonds or corporate debt with differing maturities.

Now ETFs are becoming an important piece of the puzzle, according to the AMP Capital research.  

“In some cases there is no doubt that ETFs are going to be a better option than derivatives,” Serafim told the forum. “Everyone is using CDSs because they are easy to trade and are low cost in the short term but they are actually not great instruments to use for hedging longer term.”   

Apart from the question of cost, other benefits of using ETFs include the access they can give to niche sectors such as inflation-linked bonds, specific maturity profiles within fixed income, rating bands or emerging market debt. 

ETFs are not without risks, though. The biggest of which is liquidity, according to Serafim.

“There is a risk that authorised participants could step away from making markets in ETFs during times of stress, particularly if it is difficult to price the underlying bonds,” she says.   

There may be increased danger if there is a rise in ETFs where the liquidity of the underlying securities does not match the legal liquidity of the ETF.

Algorithmic flash crashes are also a potential risk. Such an event occurred on 24August 24 2015, which had a major impact on the S&P 500 although this event was largely confined to equity ETFs. 

In the equity space, the shift in to cheaper passive investments has changed the landscape of the funds management world.  

Many active fund managers – those who research and select specific stocks - have lost market share as an increasing portion of funds under management moves to low-cost investments that simply track indices or like-for-like baskets of stocks.

In the fixed income space, the growth is also significant albeit from a lower base.

Flows into high yield, investment grade, and loans ETFs have surged by 311 percent, 369 percent and 870 percent, respectively, in the seven years to August 2017, according to data from EPFR and Goldman Sachs Co. 

Source:  EPFR Goldman Sachs Global Investment Research

Blackrock created the world’s first fixed interest ETF in 2002 and although this style of investment remains a relatively small part of the fixed interest pie, market share has now reached almost 6 percent in sectors such as investment grade credit.

Latest data shows the fixed income ETF market is close to US$1 trillion in size, with more than 741 products available to trade.

 “What our analysis shows is that there is a time and a place for use of ETFs for portfolio managers in the fixed interest space,” Serafim says. 

Stay tuned for Serafim’s white paper on this topic.

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.