Many convinced bond ETFs are ready for prime time

The dynamics of the fixed-income market — over-the-counter trading, largely limited liquidity — have prevented the exchange-traded fund industrial complex from muddying the waters of bond ETFs with the adventurousness of niche products on the equity side — airlines, restaurants, marijuana, etc.

Yet many industry participants believe fixed-income ETFs represent the greatest opportunity for growth across the ETF ecosystem.

Consider the imbalance in the current fund environment: loosely defined fixed-income products account for 17% of ETF assets under management, while U.S. bond and money market mutual funds account for 41%, according Investment Company Institute data through February.

Within the $471 billion fixed-income ETF landscape are 309 funds and 37 fund sponsors. Fourteen funds hold more than $10 billion, the largest largest of which is the $44 billion iShares Core U.S. Aggregate Bond from BlackRock (BLK) Inc. (BLK), according to XTF Inc.

According to BlackRock, global bond ETFs experienced record inflow in the first quarter of $44.5 billion.

Yet, just 20 fixed-income ETFs have average daily share volume over one million, compared to 107 on the equity side. And the survival rate for debt ETFs — 78.7% — is only marginally higher than that of equity products at 74% though asset managers have launched 5.7 times more equity ETFs, according to investment advisor Ron Rowland who tracks ETF survivorship at InvestWithAnEdge.com.

“It's closer than I thought,” said Mr. Rowland, despite the industry's opportunity to learn from a 10-year head start in experimentation on the equity side.

Still, advocates of fixed-income ETFs believe that the ETFs themselves will grease the wheels of transparency and perhaps facilitate smoother price discovery for underlying debt securities and even enhance trading in less active fixed-income markets and issues. But, even a finely tuned security pricing machine would never deign to deliver debt products as narrow or esoteric as the equity market. Some that tried have already come and gone: In 2015-"16, iShares delisted a handful of sector bond funds and narrow corporate credit funds. De-listings from other issuers have included state municipal bond funds and several country-specific debt exposures.

“Bonds will always have the index problem,” said Dave Nadig, chief executive officer of ETF.com, an independent subsidiary of CBOE.

Traditional fixed-income indexes remain in an equity-informed paradox — those entities with the greatest need or willingness to use debt financing dominate because their securities, in turn, tend to be ones that are most available.

Try though it might, the maturing fixed-income ETF market just can't seem to escape the drab notions of plain-vanilla exposures defined by credit quality and duration. (In fact, Janus Capital Management (JNS) actually introduced a short-duration income ETF in November under the ticker “VNLA.”)

“A handful of asset managers, including Invesco (IVZ) Powershares and Deutsche Bank, are bringing out products that reconsider bond index factors and weights, but there hasn't been much traction,” said Mr. Nadig.

Invesco offers two ETFs built on Research Affiliates' index methodologies that account for economic activity in a country or debt-service capacity for a company.

Yet, similar to equity ETFs, Mr. Nadig expects to see more narrowly defined bond ETFs enter the market over the next few years with the support of one or two institutions that work with an ETF issuer to design a custom product.

That doesn't mean that ETF issuers can't deliver innovation in fixed income.

“VanEck Vectors Fallen Angel High Yield Bond was really the first "smart beta' bond ETF,” said Mr. Nadig. The $767 million ETF, launched in April 2012, tracks a market-value-weighted index of once-investment-grade bonds that have dropped to junk ratings. Mr. Nadig said the company's recently launched VanEck Vectors Green Bond is another niche fixed-income product that could find broad appeal among environmental, social and governance investors.

David Mann, head of global ETF capital markets for Franklin Templeton (BEN) Investments (BEN), echoed Mr. Nadig's observations on bond indexing and ETF products.

The company, which manages $282 billion in dedicated fixed-income funds, currently sponsors two actively managed fixed-income ETFs with $221 million in assets between them.

“As an ETF investor, is your goal to track an index or is it to gain exposure to a certain area of the market?” asks Mr. Mann. “In fixed income, we're seeing a decoupling of ETFs and indexes. The numbers are becoming more compelling for active management."