Fixed income stakes out its corner in ETF universe

With the Treasury yield curve flattening, the breadth of the U.S. fixed-income exchange-traded fund market has been on full display this year.

Unlike last year, in which the predominant trade was into broad-based, medium-duration products such as the iShares Core U.S. Aggregate Bond ETF or the Vanguard Intermediate Term Corporate Bond ETF, fixed-income ETF flows indicate an investor preference for shorter-duration products.

"Ultrashort and floating-rate ETFs are punching above their weight," said Eric Balchunas, Princeton, N.J.-based senior ETF analyst for Bloomberg Intelligence. Several ETFs, such as the SPDR Bloomberg Barclays Investment Grade Floating Rate ETF and the Schwab U.S. TIPS ETF, have more than doubled their asset base in the past year to $3.8 billion and $5.7 billion, respectively.

Even over a year when nearly 50% of existing fixed-income ETFs have posted negative returns, according to Bloomberg, asset growth has been strong across the board. According to data from research firm XTF Inc., 16% of the $600 billion invested in U.S.-listed fixed-income ETFs has arrived in the past 12 months, compared with 7.8% of the $2.89 trillion invested in equity products.

But the shift to fixed-income ETF products more in line with a growing U.S. economy and increasing short-term interest rates is not indiscriminate. Performance still matters.

Over the past few years, ETF issuers have explored more creative areas in the fixed-income market, launching products that attempt to hedge interest rate risk, are designed for negative duration, or are built on inflation expectations with a long/short strategy. Several of these ETFs, though small in asset base, have returned between 5% and 15% this year alone, according to Bloomberg.

Mr. Balchunas highlights the difference between the $7 billion passively managed Invesco (IVZ) Senior Loan ETF and the $3 billion actively managed SPDR Blackstone/GSO Senior Loan ETF. The latter has added $1.5 billion in assets over the past year, while sporting a 4.3% annual yield, according XTF. It also outperformed the Invesco Senior Loan ETF, which experienced a $1.5 billion outflow against a 3.76% yield.

Also notable in flow data is the $10.8 billion iShares Floating Rate Bond ETF, with the ticker symbol FLOT, which added $4.2 billion year-to-date, making it the third-largest inflow among all fixed-income ETFs. According to BlackRock (BLK) Inc. (BLK), FLOT has a weighted average coupon of 2.96%, an effective duration of 0.15 years, and a 0.2% expense ratio.

"FLOT is more potent when it comes to reducing portfolio duration and it benefits directly from rate increases compared to other investment-grade short-duration ETFs," said Chris Mirrione, senior portfolio manager at Alesco Advisors, an institutional adviser in Pittsford, New York, with $4 billion in assets under advisory.

"Let's not forget that the core purpose of a fixed-income portfolio is to dampen volatility," said Mr. Mirrione, noting that in a rising rate environment, fixed-income portfolios with longer duration themselves become a source of volatility.

"The last six to nine months in fixed-income ETFs have been about disaggregating" the aggregate bond index, said Robert Smith, president and chief investment officer of Sage Advisory Services Ltd. in Austin, Texas. "And investors who use ETFs have to take a look at what's available and viable in this market."

Mr. Smith, whose firm has nearly $13 billion in assets under advisory in fixed-income and tactical ETF strategies, expects one to two more interest rate moves — with the potential for yield curve inversion — as other macro trends are actually keeping the longer end of the yield curve "tamped down." He points to the confluence of demand for liability-driven investment and dollar-denominated securities, and the recent flood of corporate supply that fueled dividends and buybacks.

As institutional investors look at the fixed-income ETF landscape, including mortgage-backed securities, Treasury inflation-protected securities, and short and ultrashort duration funds, Mr. Smith said they need to be mindful of "what's inside the box: where are the major flows coming from; what does the trading volume look like; who are the other owners?"

While many in the ETF market like to stress that the liquidity of the ETF is the liquidity of the underlying securities, that is most true in equities and a little more complicated in parts of the fixed-income market. Liquidity in the product still matters and "you don't want to blow up trying to get out of the trade," Mr. Smith said.

Still, investors who are buying or selling in size can sidestep secondary market liquidity concerns.

"Improvements in technology and operations have driven an acceleration in portfolio trades," said Stephen Laipply, San Francisco-based head of U.S. iShares fixed-income strategy at BlackRock.

"This is when investors work with the fund manager and a broker-dealer to contribute (or receive) eligible bonds in exchange for the appropriate ETF."