Exchange-traded products tracking baskets of bonds are becoming rapidly more popular. The first quarter of 2016 was a record one for use of fixed income ETFs with global industry inflows of $43.5 billion according to iShares.

In the simplest terms a bond is a financial instrument which operates as a guarantee by the borrower to repay money to a lender, typically accompanied by interest.

The bond market includes the debt of governments - known as treasuries in the US and gilts in the UK - and debt issued by companies comes under the banner of corporate bonds.

Because the majority of bonds offer a fixed rate of interest over a set period of time they are often known as ‘fixed income’ securities. On maturity the bondholder gets their money back - the principal - and this is usually 100% of the face amount.

The payments from a bond are also called the coupon and are more or less guaranteed unless the issuer goes bust. Should a company face insolvency bondholders are ahead of equity holders in the queue to recover their money.

Credit agencies

A rough guide to credit quality (how likely you are to get your money back) is provided by ratings agencies like Standard and Poor’s (S&P), Moody’s and Fitch. S&P and Fitch both grade bonds in descending order. The S&P scale is probably the simplest running from AAA to AA+, AA, AA-, BBB+ and so on.

Bonds rated at BBB- or above qualify as investment grade. If a security slips below this threshold the price could collapse as the number of institutional investors sanctioned to buy
non-investment grade or ‘junk’ bonds is extremely limited.

Fixed income ETFs reflect the diversity of this asset class. Director of research at WisdomTree Europe Viktor Nossek attributes the increased interest in fixed income ETFs to their ability to reflect the granularity of fixed income.

‘Investors are looking for ways to enhance interest income in an environment where bond yields are increasingly dislocated,’ he says. ‘You get zero and sub-zero yields in investment grade government credit and ultra-low but still positive yields in high-grade corporates on the one hand, and very high, but very risky yields in below investment grade issuers and emerging markets.

‘Investors look for ways to find credit yield premia without incurring significantly more credit risk and need a middle of the road solution to the low yields in high grade credit and high yields in the junk space.’

Nossek reckons that selecting the right bond is the biggest risk in this context. ‘In a diversified approach, the fixed income ETF can add a lot of value by mitigating these risks,’ he adds.

Tale of two halves

iShares owner BlackRock’s head of fixed income beta Stephen Cohen characterises the first three months of 2016 as a ‘tale of two halves’.

He says: ‘The first six weeks of 2016 were dominated by significant flows into government bonds. This was a reflection of the broader risk-off environment amidst market uncertainty and concerns over economic growth. Overall market sentiment turned in the second week of February with fixed income ETF flows reflecting the “risk on” appetite of investors.’

Investors prepared to accept limited yield as a payoff for the relative safety associated with gilts could consider a product such as SPDR Barclays UK Gilt (GLTY) which has a total expense ratio of 0.15%.

Looking at the opposite end of the risk spectrum, Deutsche Asset Management has extended its fixed income range with the launch (12 Apr) of db X-trackers iBoxx USD Emerging Sovereigns Quality Weighted (XQUA).

Deutsche’s product re-weights emerging market countries within a benchmark on the basis of a series of fundamental measures, such as global competitiveness and inflation rate, history of default, sovereign debt as a proportion of GDP and GDP growth rate.

Traditional fixed income sovereign benchmarks by contrast typically weight constituents by market value of outstanding debt. This can result in the most indebted countries having the highest weighting in the index.