Over the last several years, fixed income ETFs have represented the fastest growing asset class. Through the end of July, fixed income ETP AUM are up $35 billion versus being up $46 billion for all of last year. Investment grade and high yield have seen the most growth year-to-date. Fixed income ETFs are still relatively new, with the first ETF being launched in 2002, and all indications are for continued growth in the future.
The growth has largely come from broader adoption by advisors, who are utilizing fixed income ETFs in their asset allocation models. Many advisors have begun to embrace fixed income ETFs rather than purchasing individual bonds or bond funds. Defined maturity ETFs provide the precision of individual bonds, and the diversification benefits of bond funds.
A History Lesson on Innovation
Over the past several years, a variety of fixed income investment vehicles have been introduced, including; open-end mutual funds, closed-end funds (CEFs), unit investment trusts (UI Ts), and exchange traded funds (ETFs). The structures have attempted to solve for the fixed income needs of advisors and the clients they serve. While individual bonds have filled the need for many years, it is not always easy to source bonds, and not all advisors are equipped to properly conduct credit analysis. Also, trading bonds can be a challenge in smaller increments.
Traditional bond funds are often referred to as ‘perpetual’ maturity. The maturity of a bond fund will adjust overtime. Therefore, the maturity may not meet the client’s targeted needs. See scenario below:
If an investor purchased a bond today that was maturing in three years, they would typically receive monthly income payment and their principal back at maturity (three years). If the investor bought a bond fund, with a three-year maturity, in three years the fund would likely still have a three-year maturity. The fund manager would likely need to adjust the duration of the portfolio to adhere to the prospectus guidelines.
Fixed income ETFs have been a popular option due to their greater transparency of holdings, tax efficiencies and generally lower expenses than both mutual funds and individual bonds. Fixed income ETFs can now provide broad exposure to investment grade, high yield, municipal, and sovereign debt. They are available across a multitude of maturities, from ultra-short to long-term. Fixed income ETFs have become the investment vehicle of choice for many investors.
While fixed income ETFs have been heralded as a convenient, low-cost alternative to both bond mutual funds and individual bonds, certain investment strategies such as building a laddered bond portfolio or obtaining targeted exposure to particular points on the yield curve were still only attainable through a direct investment in bonds. That is, until the introduction of defined-maturity ETFs—a recent structural innovation that has opened the door to new opportunities for bond investors.
Defined Maturity ETFs
Defined maturity ETFs combine the benefits of individual bonds, and bond funds, in a transparent and tradable structure. Defined-maturity ETFs are a fixed-term structure. At each fund’s respective maturity date, the fund will make a cash distribution to then-current shareholders of its net assets after making appropriate provisions for any liabilities of the fund.