The explosive growth of exchange-traded funds (ETFs) and the commensurate rise of asset allocation models in fee-based investment accounts have completely transformed how advisors and investors approach and implement fixed income allocations in their portfolios, challenging some of the most important portfolio benefits of the asset class.
The general model portfolio construct of these fee-based programs is to use a sector-based approach to fixed income allocations, using fixed income ETFs as the leading implementation tool. While ETFs do provide an efficient way to get market exposure, investors need to recognize some of the key structural differences versus individual bonds when constructing a portfolio and understand that receiving fixed income exposure may not be consistent with traditional expectations of the asset class — a predictable and defined cash flow, return of principal (absent issuer default), and subsequent option to reinvest these proceeds in a potentially higher interest rate environment. As investors increasingly seek high-quality fixed income, and especially for those approaching or in retirement, it’s time to revisit the benefits of adding individual high-quality corporate bonds to their portfolios.
Fixed Income ETFs: Great Sector Diversification, But is It Fixed Income?
The monumental growth of model-driven, fee-based programs has largely expanded the bias toward a sector-based approach to constructing portfolios, and, by extension, how financial advisors manage the fixed income exposure in client portfolios. This has generally resulted in a broader acceptance of bond ETFs over the past decade as a main source for fixed income exposure.
These ETFs are an efficient way to get fixed income market exposure, especially in highly desirable sectors such as international, emerging markets and high yield. Plus, the multiple holdings within a bond ETF can accomplish many important investment objectives, such as issuer diversification.
Ease of tracking and liquidity has resulted in many investors using bond ETFs like stocks to access sectors that are complicated or hard to invest in. This ease of use has resulted in investors now confusing fixed income exposure with actual fixed income.
The equity-like qualities of a bond ETF means that coupon payments are converted to periodic dividend payments that aren’t necessarily predictable — and predictable fixed income has long been a key objective for fixed income investors.
Furthermore, while bond ETFs have strong market liquidity and diversification, there is generally no end date when investors have their capital returned. A traditional bond has a fixed maturity date, which means that investors who own that bond will receive their principal back at full par value upon maturity (absent issuer default) — a particularly appealing benefit for investors seeking the principal protection that many ETFs can’t offer.