Amid a surge in issuance of equity exchange-traded funds employing derivative-based opportunities and hedges, the fixed-income ETF market has been relatively devoid of such offerings around rates and credit.
The paucity is not for lack of liquidity, particularly in listed and over-the-counter derivatives linked to U.S. Treasuries or the federal funds fate, but more likely in the collateral and leverage required to eke out noteworthy gains from markets that tend to move slowly — and then all at once.
Moreover, the fate of past exchange-traded products trying to exploit spread differentials and the yield curve may be the limiting factor to experimentation among the nearly 700 products and $1.7 trillion in assets under management in U.S.-listed fixed-income products, said Elisabeth Kashner, vice president and director of global fund analytics at FactSet Research Systems.
Outside of broad-based bond index exposures — from Treasuries, governments, agencies and munis, to investment-grade corporates and high yield, as well as mortgage-backed securities, the first novel fixed-income offerings to take hold among investors were target-maturity products. From BlackRock and Invesco, these ETFs are built with bonds all maturing at the same time, allowing investors to ladder diversified ETFs as they would individual securities.
These products paved the way for a variety of funds that hedge interest rate risk, target duration, or even invest in on-the-run Treasuries — the most recently issued Treasuries. But as the market fills once again with speculation on the depth and timing of changes to the federal funds rate — and, indeed, central bank action around the world — ETF investors have limited opportunities to speculate on rates in the ETF market.
“This may not be such a bad thing,” Kashner said.
Based on her analysis of recent flows and returns, “ETF investors have been quite terrible at using relatively simple tactical tools in the fixed-income market,” Kashner said. For example, the iShares 20+ Year Treasury Bond ETF (TLT) “raked in billions in the past three years, despite losing about 11.4% per year during that time.”
Effective duration for TLT was 16.7 years on Aug. 2, according to BlackRock.
“None of this will stop asset managers from innovating and introducing new products into the market,” Kashner said. “Their mandate is to find a winning business strategy. Investors' mandate is to grow their capital. It's great when the mandates overlap, and not so great when things don't go to plan.”
Among those that have recently found that overlap, F/m Investments offers exposure to on-the-run Treasury bills, notes, and bonds, while making monthly dividend payments. Its US Treasury 3 Month Bill ETF has nearly $4 billion in assets two years after listing. And, over the same period, BondBloxx Investment Management has accumulated $2.3 billion across its eight target-duration Treasury ETFs.
“Having precise duration is a tool to manage risk in the current interest rate environment,” said Joanna Gallegos, co-founder of BondBloxx.
The Municipal Employees’ Retirement System of Michigan, for example, has utilized a handful of BondBloxx products to fine-tune positions in Treasuries, corporates and emerging-market debt, according to its most recent 13F ownership filing with the Securities and Exchange Commission.
“To make an ETF product targeting the yield-curve worthwhile, it would really have to be levered up beyond a level that’s prudent for a listed open-end fund,” said Harley Bassman, managing partner at Simplify Asset Management. “An ETF using solely feds funds futures might need leverage as high as 40 to 1 to be interesting.”
Simplify, which manages $5.5 billion in ETF assets, has products that include “better beta” exposure to changes in credit and rate levels, as well as equity volatility, among other strategies. “ETF products should be reasonable and perform as advertised … without a trap door,” Bassman said.
Exchange-traded products designed specifically for scenarios such as a steepening or flattening of the yield curve or the magnitude of inflation or deflation have not employed enough leverage to attract investors, according to Bassman, and have often been challenged by the timing of investor interest or market calls.
Specifically, FactSet’s Kashner points to the rise and fall of the Quadratic Interest Rate Volatility & Inflation Hedge ETF (IVOL), which was designed to target rising rates and inflation. “The ETF attracted billions in investment, only to dramatically underperform TIPS when inflation hit,” Kashner said.
The reality for fixed-income ETFs may be that creative thinking trumps overthought products.
PIMCO'S cyclical outlook, published in April, for example, called on investors to be more mindful of diverging markets, particularly on duration and regional rate moves, precisely the scenario that trapped global investors in early August.
And should fixed-income investors still want to be whipsawed by speculating on rates and the yield curve, PIMCO’s 25+ Year Zero Coupon U.S. Treasury Index ETF (ZROZ) goes far beyond BlackRock’s TLT by targeting U.S. Treasury principal STRIPS.
Its effective duration as of Aug. 2 was 27.1 years, according to PIMCO.
