Fixed income ETFs today hold $354 billion in assets, accounting for about 15% of total assets—triple their share in 2005. While the fixed income portion of the total ETF pie shrunk in 2013 as money flooded into developed equity funds, growth has remained firm in the current rising interest rate environment. Steady demand for yield, along with increased investor awareness (and use) of the multitude of bond ETF exposures available today, is likely to fuel continued bond ETF growth in 2014 and beyond.
A major theme among investors last year, as I noted in my year-end surprises post, was the great “duration rotation”: a mass exodus of investors from longer duration fixed income into shorter duration and floating rate funds. The movement can largely be explained by the concern among investors to seek protection against rising interest rates through a short duration strategy. What’s more, all categories of fixed income participated in this trend, but was most pronounced in the three largest categories – government bonds, investment grade and high yield, which make about 60% of fixed income ETF total assets. ETFs focusing on broad aggregate indices make up just one-eighth of assets. The year ended with a total of $35.9 billion of inflows into short maturity ETFs, and $128 billion into short maturity mutual funds. Clearly, this trend has been consistent among both popular investment vehicles.
We believe that investor preference within fixed income will continue to evolve in the coming year and broaden to include additional categories that offer attractive relative value. As my colleague Russ Koesterich points out in his latest Investment Directions, the Fed will likely keep short-term rates low throughout the year, and thus we expect higher real interest rates on a contained basis. From an investor perspective, some key takeaways include:
1. Avoid intermediate duration . In particular, 2 to 5 year Treasuries and TIPS appear to be the most vulnerable.
2. Look at high yield and investment grade corporate bonds . Maintain exposure to credit sectors like investment grade and high yield bonds instead of Treasuries. We are currently neutral on U.S. High Yield Credit, such as the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and neutral on U.S. Investment Grade Credit, such as iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD).
3. Consider munis for your long-term strategy . Tax-exempt municipal bonds are worth another look as fundamentals continue to improve and taxes continue to rise, although we do expect some near-term volatility in this sector. For muni exposure, consider iShares National AMT-Free Muni Bond ETF (MUB).