Are ETFs the New & Improved Fixed-Income Play?

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Lately there have been concerns about liquidity drying up in the global bond markets.

Massive amounts of liquidity have already been pumped into the fixed-income markets in response to the financial crisis and global economic slowdown.

And there are currently record levels of new bond issuance locking in ultralow interest rates. So how do all of these issues impact investors who just want to incorporate a stable allocation of fixed-income assets within their portfolios?

As usual, there are some truths to the concerns, but perhaps not to the degree some may suggest.

There are substantial structural changes taking place in the bond market that are causing a lack of liquidity when investors buy and sell, and the likelihood is that this issue will be around for some time.

On the one hand, pensions around the world are working to match their assets and liabilities by locking into matching bond positions.

These are often large, "one-and-done" trades as the intent is to hold the position to maturity. In general, the past five to six years have been characterized by investors buying bonds and bond funds, with only occasional hiccups due to interest-rate hike scares.


As volumes have slowed, there has been a loss of intermediaries standing between the market's supply and demand. That means that buyers and sellers can expect choppier waters. The good news is that much of the buying in retirement, insurance and mutual funds are light on leverage,  which reduces the magnifying effects of a sell off.

Also, it's arguable that a new type of fixed-income investor might make themselves known in the event of a bump in rates.

These bargain-hunting value investors may create a new source of liquidity that hasn't been as strong in recent years.

Not surprisingly, institutional investors and money managers have been exercising various work-arounds to address liquidity and maintain control over the fixed-income allocations in their portfolios.

Some of these tactics, like the use of futures and derivatives use, have been around for years. Others, such as the use of ETFs, are picking up steam more recently.

Indeed, fund managers used Treasury futures or credit default swaps as proxies for actual bond holdings before the crisis, although in many cases it wasn't due to liquidity as much as ease and flexibility.

These vehicles allow for more fine-grained risk exposure by slicing the risk components in a given bond holding and enabling all parties to access more of the elements they want. To be sure, liquidity also played a role, but it wasn't always a central one.

Coming more to the fore of late is the use of bond ETFs as replacements for long holdings of the bonds themselves.

These baskets replicating various fixed-income indexes up and down the yield curve and quality spectrum have generated a substantial following among institutional investors in particular, resulting in robust trading volumes on market exchanges–in effect, creating a state of liquidity unlike traditional bond investors have experienced before.

Indeed, ETFs in certain sectors such as corporate debt are proving to be more liquid than their underlying holdings.

As long as there isn't overly lopsided pressure to buy or sell a given instrument, these ETFs can provide needed exposure and liquidity for both large and small positions. They also provide inherent diversification for a given exposure, which many investors find equally appealing. So is everything in fixed-income markets fine? Has the never-ending creativity of the financial industry figured out the bond market liquidity issue and solved it?

Not so fast. Recent research questions the stability of these liquidity solutions by pointing out that credit default swaps have a shaky history of running beyond the notional basis of their derived value.

Then there's the issue of a herd-mentality run for the exits in the bond market. Everyone who is more concerned about near-term value will push their sell buttons at the same time, which will push massive sell orders through a system with very few buyers.

The result could well be an incredible gapping of spreads and greatly reduced valuations for bondholders–a very grim picture indeed.


The answers aren't easy for any investor, but they are particularly tricky for fixed-income investors engaged in more short-term or tactical strategies. Simply put, this new environment creates more risks for these types of trading profiles.

Things are a little brighter if your clients are truly long-term focused investors. In fact, arguably, if their intent is to reach a goal at some point in the future and not worry about accessing their invested principal until that time, they can largely do away with much of this worry.

They can simply buy good quality-bonds in the sectors and durations you need and let them ride through to maturity.

One reason why bond markets have always traded so differently and always had an element of liquidity risk baked in is that many investors do just that—buy and hold, and wait to get their dividends and principal back over the life of the investment.

This only works if investors are building portfolios of a certain size and can match up individual bond holdings against their fixed-income allocation needs.

Smaller accounts may find themselves leaning toward mutual funds or ETFs that match their needs.

Some products, such as unconstrained bond funds and floating-rate funds, may weather more volatile markets much better than core, plain-vanilla bond funds.

Also, high-yield may actually fare better than higher-quality issues in such an environment as their profile is more in line with equities that perform better when economies perk up.

These are all avenues worth exploring to build a fixed-income position, but a general rule of thumb is to keep the duration as tight as you can and avoid overt credit risks–particularly in sectors that might be vulnerable to a rising-rate environment like certain emerging markets. In all phases of investments, the old adages are always worth keeping top of mind: Diversify, stay as liquid as you can and invest for the long-term.

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