James R Rieger of S&P Indices explains some of the latest trends in fixed income investing, including the proliferation of ETFs, and also dispels some of the myths of buying into this asset class.

Date: Feb 2012

Tags: Fixed income, ETFs, Liquidity, Volatility, Indices, Default

• With equity markets being very volatile, there has been a shift in investing into the bond market – into bond funds, individual bonds and also more efficient vehicles like ETFs
• Fixed income ETFs have been successful because they offer investors the ability to gain exposure into what has been considered opaque, over-the-counter markets
• To make all this happen successfully, the indexing world for bonds has evolved to make sure that indices track the most liquid parts of each asset class
• The myths in relation to fixed income investing include the level of volatility and the likelihood of defaults

With equity markets being very volatile, James Rieger said in an interview that there has been a shift in investing from the stock market into the bond market – into bond funds, individual bonds and also more efficient vehicles like ETFs.

This is because investors see less volatility in the bond market, he explained, plus they can still benefit from the income-investing opportunities.

While there is a very low interest rate environment in the sovereign debt side of the fixed income world at the moment, as a result of the flight-to-quality dynamic, some investors are reaching out for yield, looking for 6%, 7% or 8%, said Rieger.

As a result, he added, these investors are looking around the world to shift their money towards higher-yielding investments – including in Asia, Australia and Latin America.

Benefits of more fixed income ETFs

Rieger said these products have been successful because they offer investors the ability to gain exposure into what has been considered opaque, over-the-counter markets.

There is typically less transparency in the bond markets, and it’s harder for investors to understand what’s going on in these market directly, he explained.

The evolution of ETFs offers access for investors into three core asset classes – sovereign debt, inflation protection issued by sovereign issuers, and corporate bonds / credit markets.

This is happening in both global and local currencies, said Rieger, giving investors the opportunity to gain exposure to and the rewards from exposure to different currencies.

Role of the index providers

To make all this happen successfully, Rieger said the indexing world for bonds has evolved to make sure that indices track the most liquid parts of each asset class.

In the government bond markets, for example, there are on-the-run bonds, which are trading in the marketplace today, and older bonds which fade away in the secondary market and see less and less trading over time.

The indices designed to track the sovereign bond markets need to recognise which bonds are traded in the marketplace so that they provide the most liquid exposure for ETF users, said Rieger.

All this requires a lot of information and market knowledge to be able to design an index which meets the investor’s objective of liquidity, he added. If all this doesn’t fall into place, there will be a lot of tracking error.

Myths of investing in fixed income

There is a myth in relation to volatility, said Rieger. For instance, when looking at volatility in the bond markets, even if interest rates go up by 100 or 200 basis points, bond prices typically don’t move as much as they would with the equivalent level of volatility in the equity markets.
 
In addition, with the bond markets, there is a lot of mystique around defaults. There is global pressure on the bond markets at the moment, coming down from Europe, he explained, having a ripple-off effect into the Asian and Latin American markets, and their ability to borrow money. This is because the perception is that a sovereign borrower may not actually repay the bondholders, said Rieger, yet such events of default are in reality very few and infrequent.

In terms of the corporate bond market, he said that the default risk is different. However, in today’s environment, he said corporations are now sitting on a lot of cash and are not investing, so they are not as high a risk as they were in the previous economic cycle.