Moves on interest rates, whether delivered or priced in, have a direct impact on the value of fixed income securities. Bond prices are inversely correlated with the direction of interest rates, which means that fixed income holdings lose value as the screws of monetary policy are tightened up. Of course, price alone is but a factor determining the overall value of a fixed income security, the other being yield; and yields move in tandem with interest rates. Capital losses thus have to be weighed up against the potential benefits of increased yields across the maturity spectrum.
The challenge for some fixed income investors going forward will be not just how to shorten duration, but how to do so while increasing yield potential. To achieve this dual goal, investors may need to take on additional notional risks and in some cases, take on foreign exchange risk.
The following is a selection of European-domiciled fixed income ETFs that can help investors achieve the dual goal of shortening duration while enhancing yield. Their metrics, taken as of mid-April 2011, are benchmarked against the iBoxx EUR Sovereign Eurozone AAA TR index (yield to maturity 2.97%; duration 6.3 years) and the FTSE UK Gilts All Stock index (yield to maturity 3.02%; duration 8.6 years). (Note - For the benefits of more accurate comparison, the chosen indices only encompass AAA-rated government bonds)
iShares Barclays Capital Euro Corporate Bond ETF (IEAC)
Yield to maturity 4.02%
Duration 4.08 years
Physically replicated
EUR-denominated (TER 0.20%)
Investors have been traditionally attracted to investment-grade corporate bonds for the expected steady income at higher yields vis-à-vis government bonds and the lower risk profile vis-à-vis equity. The overwhelming majority of corporate debt issuers are located in developed economies. However, the fact remains that by gaining exposure to both large and medium-sized corporate issuers from a variety of countries, investors will assume a higher level of notional risk (e.g. credit rating moves impacting on performance of specific sectors and/or countries).
This ETF tracks an index which is very broad in its geographical scope, with the Netherlands, France, the USA and the UK as top issuers. As per sector exposure, the ETF shows a rough 50/50 split between financial and non-financial holdings. It is worth noting that this ETF covers the whole maturity spectrum, but the bulk of EUR-denominated corporate issuance is short-to-medium-dated (e.g. over 50% of constituents have residual maturity of up to five years, with close to 75% up to the seven year mark), hence the lower duration vs. the government index benchmark of reference.
iShares Markit iBoxx GBP Corporate Bond 1-5 ETF (SLXX)
Yield to maturity 3.91%
Duration 3.22 years
Physically replicated
GBP-denominated (TER 0.20%)
This recent addition to the European fixed income ETF universe has come to fill a void for UK investors who wanted to gain exposure to the GBP-denominated corporate bond market but were wary of the long maturity bias that characterises it. Indeed, the corporate bond market in the UK is fundamentally underpinned by active demand from pension funds, which makes it larger and more liquid relative to other European countries, but also pushes issuance towards the longer-end of the maturity spectrum. For example, the long-running iShares Markit iBoxx GBP Corporate Bond ETF tracks an index with an average maturity in the 15 years mark and duration in the 9 year region.
This new 1-5 ETF restricts the tracked universe to corporate bonds with residual maturity of up to five years and minimum outstanding of GBP 100mn. The index shows a broad 60/40 split between financial and non-financial bonds, with some 45% of constituents espousing an A rating and around 30% BBB. The ETF is GBP-denominated, although geographical distribution of issuers is not restricted to the UK, with the US and the Netherlands also featuring prominently.
Lyxor EuroMTS Covered Bond Aggregate ETF (ECB)
Yield to maturity 4.80%
Duration 3.9 years
Swap-based replicated
EUR-denominated (TER 0.165%)
We have chosen this Lyxor ETF rather than alternatives from other providers as it tracks an index that maximises exposure to the higher-yielding issuers of EUR-denominated covered bonds. Spanish Cedulas (e.g. mortgage backed bonds) account for a large part of the EuroMTS index constituents. Some investors may consider this high level of exposure to an economy suffering from a housing bubble burst overhang an excessive risk to take. However, we find that most covered bond ETF alternatives from other providers are German-centric, which currently defeats the investment purpose of maximising yield vs. the chosen government bond index benchmark, although they would work for investors with a German-centric exposure to government bonds.
iShares Markit iBoxx Euro High Yield ETF (IHYG)
Yield to maturity 6.60%
Duration 4 years
Physically replicated
EUR-denominated (TER 0.50%)
Unsurprisingly one of, if not the best fixed income ETF seller of recent months, the iShares Markit iBoxx Euro High Yield ETF, launched in September 2010, was the first of its kind in the European market and has already attracted assets under management around EUR 700mn. It offers investors exposure to the non-investment grade corporate bond market by tracking an index encompassing securities with maximum original time to maturity of 10.5 years and minimum of two with a minimum outstanding of EUR 250bn.
The vast majority of High Yield issuers are industrial corporations; a fact duly reflected in the fund’s composition with close to 95% of components representing this particular sector, although for the benefits of diversification and risk minimisation the weight of each issuer in the index is capped at 5%. Geographical diversification is a key feature, with both Eurozone and non-Eurozone issuers making up the index and the fund, although being a EUR-denominated fund most issuers are eurozone based.
db x-trackers EM Liquid EuroBond ETF (DXSU)
Yield to maturity 5.85%
Duration between 7-9 years
Swap-based replicated
EUR hedged (TER 0.55%)
None of the Emerging Market (EM) Government Bond ETFs marketed in Europe would allow investors to meet the desired objective of shortening duration vis-à-vis the chosen benchmarks of comparison. This is because they all track indices measuring the performance of non-local-currency EM bonds (e.g. Eurobonds), traditionally issued in USD and with a long maturity bias to minimise repayment risk. Despite this shortcoming, we reckon that most investors would look at Emerging Markets as a yield-enhancing alternative, thus the decision to include this ETF in this selection. We have selected this db X-trackers ETF mainly for the reason that the index it tracks is EUR hedged, which might be a useful feature for Eurozone investors unwilling/unable to deal with foreign exchange considerations.
It is worth noting that US-based ETF investors now have access to ETFs providing exposure to local currency EM debt, which tends to be issued mostly in short-to-medium maturities and thus help to achieve the pursued dual investment goal of shorter duration and yield enhancement. We reckon this is a void that needs to be filled in the European ETF market.
This article was originally published May 2011.
To learn more about the differences between physical vs. synthetic ETFs, read "ETFs: Active vs. Passive & Physical vs. Synthetic."
