JPMorgan believes that when it comes to fixed income, active outperforms passive. The bank believes that the benchmark, the Bloomberg US Aggregate Index (AGG), is fundamentally flawed due to an antiquated design. It doesn’t provide sufficient diversification as it only captures just over half of the bond market. This is in contrast to equities, where passive indexes reflect a much larger share of the total market.
This is because the benchmark was created in the 1980s where fixed income was dominated by Treasuries, agency mortgage-backed securities, and investment-grade corporate bonds. Now, there are many more types of fixed income securities that are not represented in the AGG. This also means more opportunities for active fixed income managers to outperform.
Another fundamental flaw of the AGG is that borrowers with the most debt have the most weight. This means that passive fixed income investors have the most exposure to the companies with the most debt. In contrast, active managers can weigh their portfolios by factors that are more meaningful and relevant to long-term outperformance.
JPMorgan’s active funds differ from the benchmark. Instead of short-duration Treasuries, it allocates more to short-duration, high-quality asset-backed securities as these have outperformed in 12 of the last 13 years. The bank also eschews securities that the benchmark is forced to own such as low-coupon MBS. In terms of corporate bonds, JPMorgan’s active funds prioritize quality. This is in contrast to AGG as 42% of its corporate bond holdings are rated BBB.
Finsum: JPMorgan makes the case for why investors should choose active fixed income. It identifies a couple of fundamental flaws in the construction of the Bloomberg US Aggregate Bond Index.
The stronger than expected jobs report and inflation data have punctured the narrative that the Fed was going to imminently embark on a series of rate cuts. As a result, volatility has spiked in fixed income as the market has dialed back expectations for the number of hikes in 2024.
Investors can still take advantage of the attractive yields in bonds while managing volatility with the American Century Short Duration Strategic Income ETF (SDSI) and the Avantis Short-Term Fixed Income ETF (AVSF). Both offer higher yields than money markets while also being less exposed to interest rate risk which has led to steeper losses in longer-duration bonds YTD.
SDSI is an active fund with over 200 holdings and an expense ratio of 0.33%. Its current 30-day yield is 5.2%. The ETF’s primary focus is generating income by investing in short-duration debt in multiple segments such as notes, government securities, asset-backed securities, mortgage-backed securities, and corporate bonds.
AVSF is even more diversified with more than 300 holdings and has a lower expense ratio at 0.15%. It has a 4.7% 30-day yield. AVSF invests in short-duration, investment-grade debt from US and non-US issuers. The fund’s aim is to invest in bonds that offer the highest expected returns by analyzing a bond’s income and capital appreciation potential.
Finsum: Recent developments have led to a material increase in fixed income volatility. Investors can shield themselves from this volatility while still taking advantage of attractive yields with short-duration bond ETFs.
Junk-bond ETFs showed a slight uptick, suggesting potential outperformance in 2024, especially under a soft-landing scenario for the US economy, according to Michael Arone of State Street Global Advisors.
While high-yield bonds may surprise investors with their resilience, concerns persist about the Fed's tightening and its impact on economic growth. Despite recent modest gains, ETFs tracking investment-grade bonds are still in the red for the year.
Investors remain cautious about high-yield spreads and potential widening, with some preferring rate risk over credit risk. Arone suggests a diversified approach, favoring short-term debt and bonds with intermediate durations.
Finsum: Duration management could be the key to weathering the storm in 2024.
BNP Paribas Asset Management has introduced a new ESG active fixed income ETF range, starting with the BNP Paribas Easy Sustainable EUR Corporate Bond and BNP Paribas Easy Sustainable EUR Government Bond ETFs. These ETFs aim to replicate benchmark performance while integrating sustainable principles using BNPP AM's ESG methodology and exclusion policies.
The firm's Head of Index & ETF Strategies highlighted the agility of this approach in responding to controversies and adapting to changing environmental factors, aligning with sustainability label criteria. BNP made a commitment in January to improving its offerings around ESG offerings and this new suite of investments will fall in line with those goals.
Lorraine Sereyjol-Garros, Global Head of Development for ETFs & Index Funds at BNPP AM, emphasized the importance of active ESG fixed income management in navigating the challenging market landscape, offering diversification and sustainable credentials in an affordable and convenient ETF structure.
Finsum: Active bond funds could be critical to navigating the landscape of 2024 as macro volatility is looming.
Buffered ETFs are a relatively new type of fund that offers a unique risk-management approach. These funds track an underlying index to replicate its performance while providing a "buffer" against significant losses. However, this protection comes at a cost, as the fund's upside is capped at a predetermined level.
As investor interest in buffered ETFs has grown, fund providers have diversified their offerings by tracking various indices and offering a range of buffer and cap levels. Several applications for these funds have also emerged, such as the ability to put cash to use that might otherwise be held out of the market.
Investors in or nearing retirement are particularly susceptible to market volatility, often resorting to holding cash to protect against short-term market fluctuations. While providing protection, this strategy also prevents them from participating in potential market growth.
Buffered ETFs bridge this gap, allowing investors to enjoy market gains up to the defined cap while safeguarding against substantial losses. With this level of protection built into the fund, investors may have more confidence to transition a portion of their portfolio out of cash and back into the market.
Finsum: Investors in or near retirement who fear market downside now have a place to invest that cash they have been holding on the sidelines: buffered ETFS.
A major development in 2023 was the boom in active fixed income ETFs as measured by inflows and launches of new ETFs. Some reasons for interest in the category include opportunities for outperformance, lower volatility, and diversification. Ford O’Neil, fixed income portfolio manager at Fidelity Investments, sees structural reasons for the asset class’s recent success and believes it will continue.
According to O’Neil, there is more potential for outperformance in active fixed income vs equities, because indices only cover about half of the total bond market. In contrast, equity indices encompass a much larger share of the entire stock market. This means that the market will be less efficient, resulting in more undervalued securities.
Active managers are also able to better navigate the current landscape, where there is considerable uncertainty about the economy and monetary policy given more latitude when it comes to security selection. He notes that active fixed income ETFs have delivered strong outperformance vs passive fixed income ETFs over the last 8 years.
He stresses that identifying these opportunities is dependent on proper fundamental research and quantitative analysis followed by effective implementation. O’Neil is the co-manager of several active fixed income ETFs including the Fidelity Total Bond ETF (FBND) or the Fidelity High Yield Factor ETF (FDHY).
Recent economic data and tea leaves from Fed officials have resulted in more challenging conditions for fixed income. Essentially, there is much less certainty about the timing and direction of the Fed’s next move as economic data and inflation have been more robust than expected.
According to Michael Arone, chief investment strategist at State Street, this presents an opportunity with high-yield bonds given that yields are at attractive levels while a strong economy indicates that defaults will remain low. So far this year, high-yield bonds have outperformed with a slight positive return, while the iShares Core US Aggregate Bond ETF (AGG) and Vanguard Total Bond Market ETF (BND) are down YTD.
This is a contrarian trade as high-yield bond ETFs have had $387 million of outflows YTD, while fixed income ETFs have had $2.8 billion of net inflows YTD. It’s also a way for fixed income investors to bet that the US economy continues to defy skeptics and avoid a recession despite the Fed’s aggressive rate hikes.
Currently, high-yield bonds have an average spread of 338 basis points vs Treasuries. Many of the most popular high-yield ETFs have effective durations between 3 and 4 years which means there is less rate risk. Spreads have remained relatively tight and could widen in the event of the economy slowing.
Finsum: High-yield ETFs are offering an interesting opportunity given attractive yields. This segment of the fixed income market also is benefiting from recently strong economic data which indicates that default rates will remain low.
Fixed income investors have had to deal with considerable volatility over the past couple of years. The asset class has provided investors with generous yields between but has not lived up to its potential in terms of moderating portfolio volatility and serving as a counterweight to equities.
In the near term, this volatility is likely to persist especially given uncertainty about the economy and interest rates. Due to these circumstances, fixed income investors should consider actively managed ETFs which are better equipped to navigate these conditions. Active managers are able to optimize holdings and take advantage of opportunities that are unavailable to passive managers.
Not surprisingly, active bond funds have outperformed since 2022 when interest rate volatility started spiking. Yet, many advisors have been slow to embrace active fixed income ETFs. Some have stuck to actively managed mutual funds instead. According to Capital Group, 80% of assets in fixed income mutual funds are actively managed, while only 12% of assets in fixed income ETFs are actively managed.
Actively managed ETFs offer advantages such as lower costs, more liquidity, and tax advantages. Capital Group attributes slow adoption to a lack of awareness of the benefits of active fixed income ETFs and limited supply among advisors. To this end, it’s investing in educating advisors about why they should consider actively managed fixed income ETFs over other options.
Finsum: Active fixed income ETFs have many advantages over passive fixed income ETFs and actively managed fixed income mutual funds especially in the current environment. Yet, adoption has been slow for a few reasons.
Passive fixed income inflows have accelerated in recent years, yet the category still trails passive equity strategies in terms of market share and adoption. Over the last decade, passive equity funds have become the dominant way in which investors get exposure to equities. Currently, passive equity funds account for 45% of global funds, while fixed income accounts for 24%. In terms of the global market, passive equity funds account for 19%, while passive fixed income comprises just 2%.
S&P Dow Jones Indices anticipates that we will see increased adoption of passive fixed income strategies over the next decade, similar to how passive took over the equity landscape. Already, inflows and market share of passive fixed income strategies are growing at a faster rate than equities.
It should be noted that bond index funds in ETF form didn’t arrive until 2002, while equity ETFs launched in 199 and there are a limited number of fixed income benchmarks relative to equities. It’s also more difficult to replicate a bond index given that they tend to have thousands of securities, higher trading costs, more turnover, and require higher levels of oversight given maturation dates, defaults, credit rating changes, and new issues. Overall, it requires about 10 times more trades to track a fixed income benchmark than an equity benchmark.
Finsum: Passive fixed income flows have accelerated in the last couple of years due to attractive yields. Here’s why some see the category exploding over the next decade, similar to passive equities, and what’s held it back.
Two ever-present risks for fixed income investors are credit risk and interest rate risk. Rising interest and default rates diminish the value of bonds and have to be considered especially with corporate bonds.
However, some ETF issuers now offer corporate bond ETFs with less credit and interest rate risk such as the WisdomTree U.S. Short Term Corporate Bond Fund (SFIG). It currently offers a 4.76% yield and invests primarily in short-term, corporate debt with an effective duration of 2.47 years. It’s notable that SFIG can offer such generous yields despite investing in high-quality debt with over 44% of holdings rated AA or A.
Another potential catalyst for SFIG is when the Fed cut rates later this year. Currently, there are trillions on the sidelines in money market funds and some of this would migrate to funds with higher yields like SFIG.
According to BNP Paribas, another reason to be bullish on investment-grade corporate bonds is due to lower issuance and structurally, higher inflows. It sees less of a case for capital appreciation given the flat yield curve and recent rally, but it believes that yields at these levels are sufficiently attractive.
Finsum: Corporate bond investors have to be mindful of credit and interest rate risk. Investors can mitigate these factors with an ETF that invests in high-quality, short-term corporate debt.
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Entering the year, there was considerable optimism that the Fed could begin cutting rates as soon as March. However, the February FOMC meeting, recent inflation data, and the January jobs report have made it clear that the status quo of a data-dependent Fed, prevails. It’s clear that the Fed’s next move is to cut, but timing is the mystery.
This state of affairs means that the window for bond investors, seeking value, remains open. While recent developments have been bearish for bonds, investors have a chance to take advantage of higher yields if they are willing to live through near-term volatility. This is especially if they believe the Fed will cut rates later this year which will lift the whole asset class higher.
According to Bloomberg, “The US economy is testing bond traders’ faith that the Federal Reserve will deliver a series of interest-rate cuts this year.” Investors can buy the dip with a broad bond fund like the Vanguard Total Bond Market Index Fund ETF, or they can search for more yield by taking on more credit risk with the Vanguard Short-Term Corporate Bond Index Fund ETF. Both have low expense ratios at 0.04% and 0.03%, respectively, and have dividend yields of 3.2%.
Finsum: Bonds are experiencing a bout of weakness due to uncertainty about the timing and extent of the Fed’s rate cuts. Here’s why investors should consider buying the dip.
In 2023, yields started where they ended, although there was considerable volatility in between. Notably, yields dropped sharply following the collapse of Silicon Valley Bank in the spring amid concerns that it would spark a greater crisis. And, yields spiked in autumn with the 10-year Treasury yield exceeding 5% following an uptick in inflation.
In hindsight, this marked the bottom for fixed income as the Bloomberg U.S. Aggregate Index gained nearly 10% between the end of October and the new year. Looking ahead, Vanguard believes this strong performance will continue in 2024.
In terms of its outlook, it sees inflation ending the year just above the Fed’s 2% target. It believes the Fed will ease policy, although they don’t see rates returning to the same lows as the previous cycle. It also sees the yield curve steepening as short-term rates fall further.
The firm also acknowledges some risks to its outlook such as the economy continuing to be bumpy even within the context of a slowdown which could lead to false signals. Credit spreads have remained tight which means that there is greater risk in the event of a recession. High deficits mean that Treasury supply will be plentiful, adding upwards pressure to yields. Finally, inflation could re-ignite especially given geopolitical risks and prevent the Fed from easing even if the economy warranted it.
Finsum: Many active fixed income funds are being launched with a specialized focus on a particular niche. These funds have outperformed amid the volatility in the fixed income market.
For income-seeking investors, navigating the often volatile capital markets can be a tightrope walk between yield and stability. Enter income-producing ETFs, a potent blend of diversification and dependable returns. These innovative funds package high-yielding assets into a single, tradable security, offering investors a steady income stream without the burden of individual security selection.
One of the key strengths of income-producing ETFs lies in their inherent diversification. By spreading investments across a basket of assets, they mitigate the risks associated with individual maturities or underperformance. This eliminates the headache of reinvesting maturing bonds at potentially lower rates, a common pitfall for fixed-income investors.
Furthermore, income-producing ETFs typically hold less cash than their mutual fund counterparts. This seemingly minor distinction translates to a potentially significant advantage: reduced cash drag. Unlike mutual funds, which often require a cash cushion to facilitate redemptions, ETFs minimize uninvested capital, ensuring a greater portion of your portfolio actively generates income within its intended asset class.
Financial advisors seeking to craft reliable income streams for their clients should consider income-producing ETFs as a possible solution. They provide instant diversification, mitigate reinvestment risk, and maximize income potential through reduced cash drag.
Finsum: Income-producing ETFs can provide both diversification and steady returns with reduced reinvestment risk and cash drag.
The era of high yields has led to a significant boost of inflows into fixed income ETFs. Last year, short duration bond ETFs were the biggest recipient of inflows, but this started to change at the end of last year. Inflation started to move closer to the Fed’s 2% target, and the market began to price in rate cuts in 2024.
So, investors have been moving further out in the curve into intermediate and longer-duration fixed income ETFs to lock in yields for a longer period of time. One example of this can be seen in BondBloxx ETFs.
For instance, the BondBloxx Bloomberg Ten Year Target Duration US Treasury ETF has seen $49 million of inflows YTD. This is more than 50% of net inflows over all of last year. In contrast, the BondBloxx Bloomberg Six Month Target Duration US Treasury ETF only has $17 million of net inflows YTD, while it had $904 million of inflows last year.
BondBloxx has also seen similar flows from its 1 Year and 2 Year duration-focused Treasury ETFs. To appeal to fixed income investors seeking longer duration exposure, the firm recently launched 3 high-yield corporate bond ETFs with time frames of 1-5 years, 5-10 years, and more than 10 years.
Finsum: Flows into fixed income ETFs remain strong in 2024, but one definite change is that investors are favoring intermediate and longer-duration ETFs in anticipation of the Fed cutting rates.