Bond ETFs Are Hotter Than They’ve Ever Been

Inflows are rising along with the proliferation of new fixed income ETFs, including smart beta funds

Bond ETFs are hot — not as hot as equity ETFs, but hotter than they’ve ever been.

Seventy billion dollars have flowed into U.S. fixed income ETFs in the first half of this year, suggesting inflows will easily outpace last year’s $92 billion, according to Todd Rosenbluth, director of ETF Research at CFRA.

Asset managers are responding to the growing demand by introducing new fixed income ETFs — seemingly a new one every day, says Rosenbluth — and filing with the Securities and Exchange Commission to introduce even more.

(Related: Goldman Sachs Launches First Bond ETF: Portfolio Products)

Late last week BlackRock launched four new corporate bond ETFs — three investment-grade corporate ETFs, including two with positive ESG ratings, and one high-yield: iShares Edge Investment Grade Enhanced Bond ETF (IGEB), ESG USD Corporate Bond ETF (SUSC), ESG 1-5 Year USD Corporate Bond ETF (SUSB) and iShares Edge High Yield Defensive Bond ETF (HYDB).

Also last week, Nuveen filed a registration statement with the SEC for its first ESG bond ETF, the NuShares ESG U.S. Aggregate Bond ETF, months after it launched a suite of equity ESG ETFs, and Columbia Threadneedle filed with the agency a registration statement for the Columbia Diversified Fixed Income Allocation ETF, a multi-factor smart beta ETF.

(Related: Smart Beta Strategies More Popular Than Ever and Growing Rapidly: Survey)

Many of the new bond ETFs are smart beta funds, which track indexes that, unlike tradiitional indexes, are not market weighted.

The introduction of these funds is “an extension of the evolution of smart beta” equity funds that asset managers have launched, according to Phillip Yoo, ETF analyst at Morningstar. “They want to replicate that success now in the bond ETF space.”

Yoo says demand for bond ETFs is coming not only from retail investors and advisors but also from institutional investors using bond ETFs for more efficient overnight lending and hedging purposes, says Yoo.

(Related: BlackRock Sees $300 Billion From Insurers Pouring Into Debt ETFs)

Total bond ETF assets, including traditional index ETFs and smart beta funds, have grown at a compounded annual rate of 36% over the past 10 years, from just $20.5 billion in 2006 to almost $450 billion by the end of 2016, according to a study by Cerulli Associates and BlackRock, whose iShares fixed income ETFs account for about 50% of those assets.

In 2016, inflows into bond ETFs represented one-third of the flow into ETFs overall, according to the report. 

As part of the study, Cerulli surveyed 378 financial advisors with assets under management of at least $50 million and found they are increasing their use of bond ETFs for reasons of diversification, low fees and transparency, and as a substitute for individual bonds and bond funds. Tax efficiency is less of a consideration for bond ETFs than equity ETFs.

Advisors are using bond ETFs to invest in broad categories of the fixed income market, including investment-grade corporate, high-yield and short-term bonds, but future use will more specifically reflect their sentiment about bond market conditions, according to the report. Those anticipating higher rates and inflation will increase their use of floating rate, short-duration and inflation-protected ETFs, the report found.

But they shouldn't invest in any fairly new bond ETF or one whose asset size is less than $100 million, says Yoo. It's uncertain how bond ETFs will behave when the interest rate regime changes, which has already begun, and backtests for new funds reflect a limited history when rates were extremely low due to central bank policies, which are in the process of ending, says Yoo.

He suggests that advisors hold off until a fund has a track record and, for older funds, they should check the sponsor's track record in term of fund launches, the bid/ask spread over the past year and the rationale behind any smart beta or niche fund.

The proliferation of bond ETFs is not necessarily due to rising demand alone. In the case of smart beta funds, some companies, such as BlackRock, are "trying to get ahead of the curve and grab market share,” says Yoo.

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