Mass inflows to bond ETFs an ‘accident waiting to happen’

Exploding-Piggy-Bank-700.jpg

Mass inflows into bond ETFs are an “accident waiting to happen” as assets under management in the funds triple over five years.

Assets held in European-domiciled fixed income ETFs totalled €143.6bn (£129.8bn) at the end of the second quarter compared to €39.2bn in June 2012, Morningstar data shows.

Local currency global emerging market bonds ETFs attracted the largest inflows in Q2 with €1.9bn followed by US investment-grade corporate and government-bond ETFs, in an apparent risk-aversion trade as US large-cap equity ETFs suffered outflows.

BMO Global Asset Management investment manager Paul Green lists bonds alongside smaller companies, property and infrastructure as assets that are difficult to invest in “with any credibility” via ETFs.

“In the high yield bond sector at the moment the majority of flows over the last eight years have been from ETFs. That basically means that the majority of the loans and the most indebted part of the credit market has been done with zero analysis of the balance sheet.

“That’s fine when you’ve got a growing economy with a lot of central bank support and record low default rates. But when that turns that looks like a massive accident waiting to happen.”

“It’s unlikely anytime soon given where default rates are, but the central bankers are talking more about taking the punch bowl away so we shall see.”

However, 7IM senior investment manager Peter Sleep notes that the SPDR Bloomberg Barclays High Yield Bond ETF – which has the ticker JNK – launched in 2007 and survived the financial crisis.

Fixed income ETFs add liquidity to the market, Sleep says.

Some of 7IM’s largest ETF holdings are in bond funds, including high yield. For example, the asset manager holds large positions in the iShares $ High Yield Bond and EM Bond in LCY ETFs and the SPDR Convertible Bonds ETF.

Shaniel Ramjee and Andrew Cole, who co-manage the Pictet Multi Asset portfolio with Percival Stanion, say they wouldn’t invest in bond ETFs. The £159.3m fund held its maximum weighting, 20 per cent, in US high yield for much of last year, but this year holds zero as the relative risk-returns of equity improve.

“The problem with fixed income ETFs is that the biggest parts of them are the most indebted parts of them. That’s the stuff you don’t want to own,” says Ramjee.

The multi-asset fund has no allocation to investment grade bonds, but some allocation to US government bonds.

Cole says: “An equity index is a self-improving index; in a bond index the worst get bigger. There’s that structural reason why just being passive to a bond index is less of a good idea.”