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• Negative Interest Rate Policy (“NIRP”) is a “last resort” policy tool
• The UK is getting ready for “NIRP”
• The hunt for yield and alternatives to cash

 
A “last resort” policy tool
Zero & Negative Interest Rate Policy are Non-Traditional forms of Monetary Policy is a way of Central banks creating a disincentive for banks to hoard capital and get money flowing.
Zero Interest Rate Policy (ZIRP) is when Central Banks set their “policy rate” (a target short-term interest rate such as the Fed Funds rate of the Bank of England Base Rate) at, or close to, zero.  ZIRP was initiated by Japan in 1999 to combat deflation and stimulate economic recovery after two decades of weak economic growth.
Negative Interest Rate Policy (NIRP) is when Central Banks set their policy rate below zero.  Japan, Euro Area, Denmark, Sweden are currently using a NIRP. US & UK are currently using a ZIRP, and are considering a NIRP.
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Fig.1. Advanced economy policy rates

Whilst bond prices may imply negative real yield, or negative nominal yields, a NIRP impacts the rates at which the Central Bank interact with the wholesale banking system and is intended to stimulate economic activity by disincentivising banks to hold cash and get money moving.  A NIRP could translate to negative wholesale rates between banks, and negative interest rates on large cash deposits, but not necessarily retail lending rates (e.g. mortgages).

Ready, steady, NIRP
Negative Interest Rates were used in the 1970s by Switzerland as an intervention to dampen currency appreciation.  .  It was the subject of academic studies and was seen as a last resort Non-Traditional Monetary policy during the Financial Crisis of 2008 and during the COVID crisis of 2020. Sweden adopted NIRP in 2009, Denmark in 2012, and Japan & Eurozone in 2014.  The Fed started looking closely at NIRP in 2016.

According Bank of England MPC minutes of 3rd March 2021, wholesale markets are generally prepared for negative interest rates as have already been operating in a negative yield environment.  By contrast, retail banks may need more time to prepare for negative interest rates to consider aspect such as variable mortgage rates.

There are arguments for and against NIRP.  The main argument for is that NIRP is stimulatory.  The main argument against is that NIRP failed to address stagnation and deflation in Japan and can create a “liquidity trap” where corporates hoard capital rather than spend and invest.

The hunt for yield
With negative interest rates, there will be an even greater hunt for yield.    We look at the some of the options that advisers might be invited to consider.

• Foreign Exchange: This is what drove many Japanese retail investors to open savings accounts in foreign currencies that – despite the exchange rate risk – paid a greater interest rate.
• Structured Retail Products may offer high headline yields, these typically involve a complex return pay-off or conditionality linked to an index level such as the FTSE 100.  Return and risk cannot be created or destroyed.  Structured Products simply re-distribute the pay-offs between issuer and investor and – in aggregate – represent market returns less product costs and commissions.  We do not consider these as appropriate alternatives to Cash in a NIRP environment, or at all.
• Mini-Bonds that offer too-good-to-be-true interest rates that lure investors in to speculative investment schemes have, thankfully, been banned for promotion to retail investors.
• Up-risking: Alternative yield options necessarily require a modest “up-risking” relative to the zero-volatility and guaranteed (if paltry) return on cash deposits.  This up-risking could include money market funds (which will also come under interest rate pressure), longer dated bonds, and ultimately equities.

Getting the balance right between additional non-negative income yield and additional downside risk will be key for investors and their advisers when preparing for and reacting to a NIRP environment.

1. Bond indices have evolved from being simple broad benchmarks to span more targeted dimensions of the bond market
2. Increased granularity enables investors to use bond ETFs not only for broad access to the bond market, but also specific portfolio applications, such as yield pick-up, inflation protection and duration targeting
3. The efficiencies of the ETF structure means that investors can access these exposures in a way that is targeted, transparent and liquid

 
In this report, we analyse the data around a selected opportunity set of bond indices as represented by London-listed ETFs.  The report covers global, USD, EUR, GBP and Emerging Market bond markets, for aggregate, government, corporate, high yield and emerging market exposures.
 
Whilst the bond market dwarfs the equity market, the majority of ETFs are focused on equity exposures.  That is gradually changing with growing acceptance of bond ETFs as a convenient and liquid way of accessing targeted bond exposures by geography, issuer type, credit quality, or maturity profile.
 
In this report, we:

1. define the opportunity set of bond exposures under analysis
2. consider key applications from a portfolio construction perspective
3. outline key characteristics of this opportunity set
4. analyse performance of this opportunity set
5. summarise cost of accessing this opportunity set

For more information and important notices, view the full report.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: This article references research by Elston Consulting that is sponsored by State Street Global Advisors Limited.  I wrote this article myself, and it expresses my own opinions.
Additional disclosure: This article has been written for a UK audience. Tickers are shown for corresponding and/or similar ETFs and may be prefixed by the relevant exchange code, e.g. “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. This blog reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates. For information and disclaimers, please see www.ElstonETF.com All product names, logos, and brands are property of their respective owners. All company, product and service names used in this website are for identification purposes only. Use of these names, logos, and brands does not imply endorsement.  Image credit: Elston; Chart credit: n.a.; Table credit: n.a.  

1. The secondary market liquidity that bond ETFs enable is not well understood
2. While internal liquidity is only ever as good as the underlying asset, bond ETFs offer greater external liquidity than traditional bond funds
3. Broader range of more nuanced exposures is making targeted bond investing more accessible to more investors than ever before

What’s new?
A bond ETF is not brand new: the first bond ETF launched back in 2002.  But they are gaining traction, and as adoption increases the breadth and depth of bond ETFs have also broadened.
In my first DIY multi-asset ETF portfolio back in 2008, the main bond ETFs available back then were for broad exposures like Gilts, Index-Linked Gilts and Corporate Bonds.  Fast forward over ten years and there’s the ability to access much more targeted exposures.

Investors can access both corporate and government bonds for GBP issuers as well as for major currency issuers such as USD and EUR, both unhedged and hedged to GBP.  Furthermore, within these opportunity sets investors can select from a range of investment term options, whether short-term (e.g. <5 years), medium term (e.g. 5-10 years), or long-term (>10 years).  As well as high yield bonds, more specialised bond exposures are also increasingly available.  So whatever the exposure, there is an investable index to express it, and increasingly an ETF to track it.

But what is a bond ETF and what are the benefits?
A bond ETF is simply a bond fund that can be bought or sold on an exchange, like a share.
This has three benefits: it enables access, provides diversification and creates liquidity.
According to a recent survey of UK managers, while the access and diversification points are readily understood, there are concerns about liquidity.

• Access: Buying bonds directly necessarily requires significant size given the typically higher nominal values of bond issuances.  This may not an issue for institutional investors, but it locks individual investors out of accessing this asset class most fully.  Buying a bond through a fund makes bond investing more accessible, as investors can access their target exposure at much lower nominals.
• Diversification: Higher nominal values of going direct also limits the number of bonds that can be held in a portfolio, increasing concentration risk.  By accessing bonds through a fund structure, investors get access to a diversified portfolio of bonds for that particular exposure.
• Liquidity: Some managers are concerned as regards the stress put on a bond ETF where there is a  mass of redemptions.  If it becomes harder to shift the underlying assets, then doesn’t that create additional risks?  Well, yes, but the same could be said of any fund whether exchange traded or not. 

Understanding bond ETF liquidity
Ultimately the liquidity of a bond fund, whether a traditional fund or an ETF is only as good as the underlying asset.  We can term this “internal liquidity”.  But if liquidity of a fund itself is a concern then you are probably better off in a bond ETF than a traditional bond funds.  Why is that?  Simply put the stock exchange creates a secondary market for ETFs (buyers and sellers of bond ETFs trading with each other without necessarily requiring a creation or redemption of units of the bond ETF that would impact underlying bond liquidity).  We can term this “external liquidity”.
If liquidity of the underlying asset class was a concern and you wished to exit a traditional bond fund, your redemption would be at the discretion of the fund provider and in extremis, you may find yourself gated.
So if bond liquidity is a concern, avoid traditional funds and stick to ETFs: there’s a secondary market for them other than the fund issuer.

Additional liquidity of bond ETFs
By way of example, 2017 provided a stress test for the bond market – in particular high yield bonds.  The findings are reassuring.

When high yield bond yields spiked in March 2017 and high yield bond values came under pressure, we can see how high yield bond ETFs actually fared in these challenging conditions. The volumes of the secondary market trading between investors buying/selling on exchange (which requires no trading of the fund’s underlying securities) eclipsed net share redemptions (which does require trading of the underlying securities) by a significant factor.  The volumes on secondary markets increased to an average of $12.7bn in the first two weeks of March (versus a previous nine-week average of $6.7bn), whilst the net redemptions of high yield bond ETFs was only $3.5bn (representing 6.1% of total assets).
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A similar resilience was exhibited in November 2017.  So far from triggering a liquidity stampede in the underlying holdings, the presence of secondary market enabled investors to trade the ETF holding those bonds amongst themselves.  This is why secondary market liquidity is seen as an advantage, rather than a disadvantage.
Secondary Market Trading of High-Yield Bond ETFs Increased When Yields Rose in 2017, 29-Dec-16 to 29-Dec-17*

Source: ICI 2018 Factbook. Figure 4.6
 
The ratio of secondary market volume to net share issuance is therefore one measure of bond ETF liquidity, but the most indicative measure of bond ETF liquidity is bid-ask spread.

Conclusion
Innovation for bond ETF investing is focused on more nuanced index design and construction of bond ETFs which provide the tools managers need to reflect their views as regards issuer type, term and credit quality when allocating to bonds.  The adoption of bond ETFs is demand-led as it enables access, provides diversification and creates liquidity.  This is and should be welcome to investors large and small.
 
For more information and important notices, view the full report.



Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: The article includes references to research by Elston Consulting that was sponsored by State Street Global Advisors Limited.  I wrote this article myself, and it expresses my own opinions.
Additional disclosure: This article has been written for a UK audience. Tickers are shown for corresponding and/or similar ETFs and may be prefixed by the relevant exchange code, e.g. “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. This blog reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates. For information and disclaimers, please see www.ElstonETF.com All product names, logos, and brands are property of their respective owners. All company, product and service names used in this website are for identification purposes only. Use of these names, logos, and brands does not imply endorsement.  Image credit: n.a.; Chart credit: ICI; Table credit: n.a.  ​

1. Diversification benefits are main attraction over direct approach
2. Managers actively consider issuer type, term and credit quality when allocating to bonds
3. Shift from broad to more nuanced exposures underway

 
We conducted a Survey of senior portfolio managers and decision makers from firms whose combined assets under management is in excess of £500bn.  The survey was designed to get a better understanding on how those managers approach bond investing.
 
Our key findings based on the survey are summarised below:

• Inclusion of bonds within portfolio for implementation of strategic and tactical views is a given
• Managers actively consider issuer type, term and credit quality when allocating to bonds but may be less aware of the range of more nuanced bond exposures now available to reflect these different dimensions
• Managers seem to favour direct bond exposure at present over active funds or index funds/ETFs.
• Adoption of bond ETFs is not therefore linked to the classic active/passive debate, but is more utilitarian in nature.
• Whilst there is reasonable awareness of bond ETFs, we believe there is scope for increasing education around advantages of using bond ETFs over direct securities for diversification and accessibility purposes
• Diversification and targeted exposures were cited as the key benefits, whilst index construction (overweight largest issuers) and liquidity were cited a key concern.
• These concerns show there is a lack of awareness around 1) how bond indices are actually constructed (the largest issuers within an index are not necessarily the most indebted firms), and 2) that whilst bond ETF liquidity is only as good as its underlying assets, the ability to trade bond ETFs on exchange means there is a secondary market which does not existing for traditional active or index funds.

For more information and important notices, view the full report.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: The data in this article comes from an Elston ETF Research report “Bond ETF Investing Survey” that was sponsored by State Street Global Advisors Limited. We warrant that the information in this article is presented objectively. For further information, please refer to important Notices and Disclosures in that Report which is available on our website www.ElstonETF.com
This article has been written for a UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. This article reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates. For information and disclaimers, please see www.ElstonETF.com
Image credit: Elston Consulting; Chart credit: Elston Consulting; Table credit: Elston Consulting

BMO has lowered the cost of its bond ETF range by -43% from 30bp to 17bp as it passes through the economies of scale to end investors.

BMO’s bond ETFs offer access to the global corporate bond market, whilst giving investors the choice to select their preferred exposure, as defined by maturity.

iShares offers the most popular London-listed global corporate bond ETF (CRPS).  This tracks the Bloomberg Barclays Global Aggregate Corporate Bond Index at 0.20% TER.  Its GBP-hedged version (CRHG) understandably costs slightly more at 0.25% TER for the convenience of in-built currency hedging.

Like iShares, BMO also offers a GBP-hedged range, but has a more nuanced approach by offering investors a choice of three different ETFs each with a different maturity range: 1 to 3 years (ZC1G), 3 to 7 years (ZC3G) and 7 to 10 years (ZC7G).  This compares to the average maturity of the main index of approximately 9 years.

The ability to access this exposure by maturity is particularly useful for UK institutional and pension scheme investors who are looking to construct liability-relative portfolios where both duration and currency controls are important to avoid asset-liability mismatches.

The BMO range has gathered some £117m AUM since launch in November 2015 (inflows of £3m per month on average).  This compares to iShares' CRPS size of £824m since launch in September 2012 (inflows of £12m per month on average).

As the advantages of bond investing with ETFs become more apparent (secondary liquidity, transparent exposure, daily disclosure of underlying), we expect increasing price competition and greater nuance within the most popular strategies.

ETFs mentioned
ZC1G     BMO Barclays 1-3 Year Global Corporate Bond (GBP Hedged) 0.17% TER
ZC3G     BMO Barclays 3-7 Year Global Corporate Bond (GBP Hedged) 0.17% TER
ZC7G     BMO Barclays 7-10 Year Global Corporate Bond (GBP Hedged) 0.17% TER
CRPS      iShares Global Corporate Bond (Unhedged) 0.20% TER
CRHG     iShares Global Corporate Bond (GBP Hedged ) 0.25% TER
(All ETFs mentioned are UCITS ETFs listed on the London Stock Exchange)

• WisdomTree has recently launched an ETF (COCB) providing access to Contingent Convertible Bonds
• Contingent Convertible Bonds or "CoCos" have both bonds and equity-like characteristics.
• CoCos pay an attractive income with higher credit quality than traditional high yield bonds, and have additional diversification benefits

What are CoCos?
Following the 2008 financial crisis, banks had difficulty issuing traditional debt securities, and had to sit on a large amount of capital to ensure their balance sheet strength was maintained.

CoCos were created as the issuing banks flexible friend.  This is because are designed to absorb losses when the balance sheet of the issuing banks weakens below a threshold level.

Losses can be absorbed by the CoCo converting into equity or suffering a write-down of its principal value making it more flexible than traditional bank securities.  To offset the risk of loss, CoCos are issued with a higher coupon than traditional bank bonds.

Accessing CoCos
Whilst bond funds may include CoCos, direct access to CoCos as a targeted allocation was previously only available to institutions who could meet minimum issuance sizes from one or more issuer.

By accessing CoCos using an ETF, the minimum investment drops to $100, and the ETF is diversified across 29 CoCos from 24 different issuers.

Why include CoCos in a portfolio?
Convertibility into the issuing bank’s shares means that CoCos provide an exposure that has both bond and equity-like characteristics.  When there is higher risk of balance sheet stress, CoCo's behave more like equities.  When there is lower risk of balance sheet stress, CoCo’s behave more like bonds.

CoCos' moderate correlation to equities and low correlation to Corporate and Government Bonds makes them a useful diversifier from a portfolio construction perspective.

Fig.1. Correlations to major asset classes

In summary, CoCos have offered solid risk-adjusted returns (Sharpe Ratio), and have a low correlation to bonds from a diversification perspective and a higher income with better credit quality relative to traditional high yield bonds.