Four reasons why bond ETFs are attracting attention

There’s been a lot of money flowing into passively managed bond funds. Kyle Caldwell examines the reasons behind this trend. 

Passively managed bond funds have their biggest positions in companies or countries with the most debt.

On the face of it, going down the passive route for bond exposure is unappealing given that companies with more debt may be less secure financially.

In contrast, active fund managers have greater freedom to assess the financial strength of bond issuers as they can cherry-pick the best bonds to fit into their strategy.

• Invest with ii: Investing in Bonds | Free Regular Investing | Open a SIPP

However, bond exchange-traded funds (ETFs) have been proving very popular. This fund type posted the highest estimated net inflows in the European ETF industry for May, according to data firm Refinitiv Lipper. Over the month, €4.3 billion (£3.7 billion) was invested.

Our recently written guide on bond ETFs explains how these funds work, and the risks of owning them. 

Refinitiv Lipper points out that the high demand for bond ETFs is not a new trend. In 2022, passive mutual bond funds attracted £11.6 billon, while bond ETFs netted £6.2 billion. In contrast, actively managed bond funds saw outflows of more than £20 billion.

So, what are the drivers behind investors flocking to passive for fixed income? According to Dewi John, head of research UK and Ireland at Refinitiv Lipper, cost is one of the key factors. He points out that passive bond funds are on average between 19% and 30% cheaper than active ones, depending on the sector.

Moreover, he points out that recent research carried out by Refinitiv Lipper, which pitted the performance of active and passive bond funds against each other, found that “passive investors are getting broadly similar results to active”.

Another factor at play is that it is easier to keep track of how a passive bond fund behaves.

John adds: “An index fund can be plugged into an asset allocation model, and it will continue to fit, as the way in which it invests is not going to change. Whereas, it is harder to model how an actively managed fund will behave.”

Liquidity is another attraction, with John noting that bond ETFs are easier to get out of. This is particularly the case for professional investors who are withdrawing large sums of money.

• What you need to know about bond ETFs 
• Benstead on Bonds: are bonds now the only game in town for income?
• How to prepare your portfolio for the new era of spikeflation

As far as retail investors are concerned, most funds are “liquid”, meaning that investors should not have problems withdrawing their money. Liquidity is basically a fund’s access to liquid assets, for example, cash, or those assets that can be quickly and easily converted to cash without losing value. Most funds are highly diversified and hold a wide spread of investments, so they are unlikely to have liquidity problems. Two areas that are vulnerable to liquidity problems are funds that invest in commercial property, and those with exposure to unlisted companies.

The final driver for high demand for bond ETFs, notes John, is that after a dismal 2022 for bond markets some investors have been topping up exposure in an attempt to take advantage of lower bond prices and higher yields.

Rising interest rates caused bond prices to fall sharply last year. As a result, the “safest” multi-asset fund sector produced the biggest losses, due to having a greater proportion of its assets in bonds.

The sharp sell-off in bond prices led to steep declines for two bond fund sectors considered to be the most cautious. In 2022, the average UK gilt fund lost 23.9%, while the typical UK index-linked gilt fund is down 35.3%.

The lesson for investors is that even safe bond funds can fall sharply over a short-term period when there is an unfavourable market backdrop, which has been the case for bonds because of rising interest rates.

In the case of UK index-linked bonds, the sharp falls in bond prices have ultimately outweighed their inflation benefits. Such funds offer inflation protection by paying a level of interest linked to price rises in the market where the bonds are issued.

Popular bond ETFs traded by interactive investor over the past year include: iShares Core UK Gilts ETF, iShares USD Treasury Bond 20+yr Uctis ETF, iShares USD Treasury Bond 1 –3yr Ucits ETF, and Vanguard UK Gilt Ucits ETF.

Investors looking for passive exposure to bond markets can also consider index funds. Interactive investor’s Super 60 investment ideas list includes the Vanguard Global Bond Index and Vanguard UK Government Bond index.