Fixed Income ETFs – Racing Toward the Next Trillion in AUM
US-listed fixed income ETF assets have grown at an annualized rate of 33% since 2002 to reach $1.58 trillion.1 Globally, fixed income ETF assets have surpassed $2 trillion.2 And, according to a recent Cerulli survey, fund managers believe fixed income ETFs will be the primary catalyst for the entire ETF industry’s growth.3
Unlocking Liquidity With ETFs
Fixed income ETFs offer investors exposure to a wide range of debt securities, combining the benefits of bonds — such as income generation and risk mitigation — with the flexibility, transparency and, most importantly, the liquidity of the ETF wrapper.
ETFs offer significantly more liquidity than the underlying bonds because ETFs have two layers of liquidity, from:
- Primary market creation and redemption
- Secondary market trading on exchanges
This superior liquidity facilitates trading in otherwise highly illiquid bond markets, setting ETFs apart from individual bond portfolios and mutual funds, where trading illiquid bonds can be costly and time-consuming.
And while the first fixed income ETFs were broad index funds, today ETFs cover all corners of the bond market from investment-grade credit and high yield, to municipals, senior loans, and emerging market debt. Plus, active fixed income ETFs are gaining in popularity. This wide range of exposures has helped create a more centralized and transparent fixed income marketplace.
Rate Volatility Likely to Fuel Bond ETF Growth
Where might the next wave of fixed income growth come from? Think about how in the past year — in response to generationally elevated yields, market volatility, mixed economic fundamentals, and evolving Federal Reserve (Fed) policy — investors have gravitated to the relative safety and reliability of money market funds.
The $1.2 trillion of inflows to US money market funds last year pushed their aggregate net assets to a new record of $6.4 trillion.4 Net inflows have continued this year due to money market funds’ comparatively higher yields and the Fed holding rates steady. But when the Fed begins cutting interest rates, the direction of money market fund inflows is likely to reverse.
With cash-like exposures exposed to new challenges from rate volatility, what fixed income asset classes might attract investors? Active core bond ETFs as well as a mix of short and intermediate investment-grade bond ETFs will likely see inflows from investors seeking reliable income with greater stability.
Record Inflows Into Active Funds
In the US, active funds attracted more than 36% of US fixed income ETF inflows through the first half of 2024.5 I expect active bond ETFs will continue to garner major market share and bring value to portfolios in a range of ways, from core and core-plus strategies to Treasurys:
- Core and core-plus strategies: These strategies usually blend traditional and non-traditional fixed income asset classes to pursue the highest possible return over a full market cycle. With the flexibility to invest in mispriced securities, through active sector allocation and security selection, these strategies may offer better protection against interest rate risk and credit risk than benchmark-linked core or aggregate bond strategies.
- Treasury holdings: An index-tracking ETF may need to hold the newest, most-liquid Treasury bonds that have recently been added to the benchmark. Meanwhile, an actively managed ETF may have the flexibility to buy off-the-run Treasury securities that offer better relative value.
Thrifty Titans: Low-cost Bond ETFs
On the opposite end of the fixed income ETF spectrum, low-cost fixed income ETFs are attracting substantial assets. In fact, low-cost ETFs have accounted for 53% of all inflows so far this year.6 That’s no surprise given that fees for fixed income ETFs are 54% lower than their mutual fund peers.7 Fixed income ETFs’ median net expense ratio is just 0.29% versus 0.63% for mutual funds. Active fixed income ETFs’ median net expense ratio is also lower than for active mutual funds, 0.40% versus 0.65%.8
Of course, it’s important to consider the total cost of ownership (TCO) — the expense ratio plus trading and holding costs — for any investment. And, in addition to reducing operating costs, which lowers the expense ratio, ETFs’ unique creation and redemption process also works to reduce TCO, due to the following:
- Because ETFs offer two markets for trading, both primary and secondary, they provide greater liquidity to support quick reallocation of portfolios or the ability to meet investor redemptions.
- Because they tend to distribute fewer capital gains than mutual funds, ETFs are more tax efficient. In 2023, 31% of equity and fixed income mutual funds distributed capital gains compared to just 2% of ETFs.9
The Next Wave of Fixed Income Innovation
The current popularity of active and low-cost ETFs aside, in the future investors are likely to see the emergence of increasingly precise ETF exposures around key fixed income asset classes. And as bond yields hover near their highest levels in a generation, I believe there is a real opportunity for outcome-oriented ETFs to drive growth, specifically income funds and exposures that deliver relatively high distributions.
What’s Next for the Global ETF Market?
In our latest ETF Impact Report, explore top trends and predictions for the future.