Institutions Seek Fixed-Income ETFs

Changes in bond market conditions and institutional portfolio strategies are driving the largest U.S. investors to add more exchange-traded funds (ETFs)—especially those built on fixed-income investments.

The increased attention means fixed-income ETFs are poised to take on a bigger role in institutional portfolios, according to a new report, “Institutional Investors Turning to Fixed-Income ETFs in Evolving Bond Market,” from financial research and consulting firm Greenwich Associates. 

The report shows institutional investors are making sweeping changes to their fixed-income portfolios in response to post-financial-crisis regulatory changes in U.S. bond markets. Also important to the shifting strategies is the emergence of a rising interest rate environment, and the related expectation that rates will continue to tick up for some time as the U.S. and global economies strengthen.  

Andrew McCollum, a consultant with Greenwich Associates, explains these factors are driving institutional asset managers to shorten the average duration of bond investments and to seek new sources of dependable yield that aren’t as exposed to interest rate risk. McCollum says a survey underlying the new report shows current users of fixed-income ETFs will slowly but steadily increase their use of the products, and more non-users will elect to employ at least some fixed-income ETFs in their portfolio strategies.  

The report shows about 60% of current institutional ETF users say they will allocate more than 10% of fixed-income assets to ETFs during the coming year, including almost one-third allocating between 10% and 30%. One-third of the institutions now using ETFs say they plan to increase their allocations to these products in the next 12 months, including 43% of investment managers and 38% of institutional funds.

While most current users expect to increase allocations to ETFs by between 1% and 5%, about one in four users plan an increase of 6% to 10%, and about one in 10 expects to boost ETF investments by more than 20%. One in five non-users will start investing in fixed-income ETFs in the coming year, the report shows.

Institutions indicated their top application of fixed-income ETFs is a strategic one—to obtain passive exposures in the “core” component of core-satellite portfolio constructions. The report goes on to argue that the evolution from tactical to strategic use of ETFs appears to be taking place even more rapidly for the fixed-income asset class, perhaps due to the challenges of investing in fixed-income secondary markets.

The report shows institutions most often cite ease of use, liquidity, single-trade diversification and lower trading costs as the main benefits to employing fixed-income ETFs.And when it comes to selecting an ETF provider, Greenwich Associates finds pricing represents a key driver. Thirty-eight percent of institutions name “better pricing” as one of the three most important factors considered when selecting an ETF provider. The next closest factors are “liquidity” and “breadth of product offering,” which are named as the top consideration by about 21% of institutions.

“Based on those factors, the fixed-income ETF users participating in Greenwich Associates’ research name iShares/BlackRock as their preferred provider of bond ETFs,” McCollum says.

More information on Greenwich Associates and the firm’s fixed-income ETF report is available here.