Even the Fed, Low Rates Aren't Keeping Investors from Bond ETFs

With each passing month, data confirm advisors and other professional (and retail) investors continue pouring billions of dollars into exchange traded funds.

Inflows are on a torrid pace as the annual flows record was topped just seven months into the year. Casual investors can be forgiven if they assume fixed income ETFs aren't holding up their ends of the bargain. After all, 2021 is a trying time in the bond market thanks to inflation, low yields and a Federal Reserve apparently intent on boosting interest rates sooner-than-expected.

Just two bond ETFs – the Vanguard Total Bond Market ETF (NYSEARCA:BND) and the Vanguard Short-Term Bond ETF (NYSEARCA:BSV) – are among the top 10 ETFs in terms of 2021 inflows.

That statistic is misleading because 1) stocks, broadly speaking, are performing well this year and 2) plenty of fixed income ETFs in addition to BND and BSV are packing on the assets, just not enough to crack the top 10 asset gatherers.

Usual Suspects Driving Bond ETF Flows

Last year, bond ETFs eclipsed $200 billion in annual flows for the first time, topping the all-time of just over $150 billion in 2019. Alright, so much of last year's flows are attributable to the coronavirus bear market and the Fed stepping up to buy a variety of bond ETFs to support credit market, but as of Sept. 22, year-to-date fixed income flows evenly match those seen in 2019. Interestingly, it's not just one constituency driving cash to bond ETFs.

“Fixed income ETFs have seen broader adoption by institutional investors, advisors, RIAs and individual investors. Fixed income ETFs have provided pension funds and insurance companies a tool to streamline portfolio construction and effectively manage portfolio risk,” says Fran Rodilosso, VanEck head of fixed income ETF portfolio management.

Insurance companies are getting in on the fun, too. In the first quarter, the bulk of insurance providers' trading activity took place in fixed income ETFs and with more institutional activity in this segment, spreads come down, lowering costs for investors.

“Broader adoption of fixed income ETFs by institutional investors may improve liquidity for all shareholders and drive down trading costs. This trend may drive further growth in fixed income ETFs, which remain a small fraction of total fixed income assets,” adds Rodilosso.

Bond ETFs Have Plenty of Growth Engines

At a time when Treasury yields are at rock-bottom levels, credits spreads are depressed and the specter of a rate hike is rising, it may seem counterintuitive that there's momentum for bond ETFs, but there is and there are good reasons why that's the case.

Issuers are seizing momentum in the sustainable investing space, realizing investors want green in their fixed income portfolios and that's supported by the fact that green and sustainable bond issuance is expected to hit $650 billion this year.

Additionally, flows to boring old municipal bond ETFs, as the chart below confirms, are soaring this year due to President Biden's effort to raise taxes on the wealthy.

Courtesy: VanEck

“Related to munis, fiscal policy changes under consideration by the Biden administration to raise the top income tax bracket is driving record flows into the municipal bond funds. Munis appear to be a vehicle of choice for investors trying to navigate the upcoming tax regulations and looking to generate tax-advantaged income,” notes Rodilosso.

Even if the one-off circumstances of 2020 are glossed over, it's clear flows to bond ETFs are going to continue in out-sized fashion. Fortunately, advisors now have the tools to offer clients much more than prosaic strategies and that could improve as the basic bond ETFs of yesteryear aren't getting the job done in 2021.

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