Unrivalled innovation in ETFs

Unrivalled innovation in ETFs

While bond yields have been gradually rising and spreads widening, the gains haven’t been enough to offset inflation. Real yields are often still negative, just as they have been over the past few years. Many investors have realised that limiting their portfolios to government and investment-grade credit, and even conventional high yield bonds, just wasn’t getting the job done. Fortunately, fixed income ETFs offer efficient exposure to markets that may help you achieve more favourable outcomes. 

Instead of relying on someone else to make decisions that may or may not align with your own views, ETFs put the power in your hands. They offer the choice from a wide range of exposures so you can adjust your portfolio to best reflect your views on important factors such as interest rates, inflation and geopolitical risks. 

If you expect persistently high inflation will result in further rate hikes this year by the Fed and other major central banks, you may want to reduce duration. You could do this by selecting maturity buckets, for example a 1-3 year or 3-7 year US Treasuries ETF, although with yields on these bonds only around 1.5%, it may not satisfy your income requirement. Here, we will look at some of the more innovative ETFs we offer that can provide an enhancement in yield and relatively short duration. 

Yield versus duration for fixed income asset classes ¹

Uncorrelated assets may yield a variety of benefits

Hybrid securities are among the most innovative income segments accessible through our ETFs. They have characteristics of both bonds and equities, hence the “hybrid” term, and their unusual characteristics give them lower duration than traditional credit assets and attractive levels of yield. And that’s not all. While hybrids may carry higher risks on their own, they can potentially improve the overall risk-return profile of a portfolio when you combine them with core assets such as government and investment-grade corporate bond holdings. 

Some fixed income segments behave in ways that largely negate the key benefits of diversification. Deciding whether prevailing conditions favour taking on credit or duration risk is important, but you should also think about what overall impact the addition of an asset can have in terms of a portfolio’s expected risk and return. Is the expected benefit compensating you sufficiently for the extra risk? 

Here, we look at three types of hybrid securities, each available through our ETFs: Additional Tier 1 Capital Bonds (“AT1s”), Corporate Hybrid Capital Securities and Preferred Shares. 

AT1s are a special type of bond introduced to the European banking system in 2009 as part of Basel III regulation. They are issued by banks and other large financial institutions to prevent contagion in the financial sector by acting as a readily available source of bank capital in times of crisis. 

An AT1 bond’s yield is driven by the subordination and convertibility elements as opposed to conventional high yield securities being driven by the riskiness of the issuers. An AT1’s yield should be higher than any of the senior debt issued by the same entity, while the credit quality of a typical basket of AT1s is generally higher than you’d see with traditional high yield.  

The interest rate risk (duration risk) is typically lower for AT1s versus a basket of traditional high yield bonds, because AT1s have a call date usually after five years of issuance. Almost every AT1 that’s been issued so far has been called on the first call date, partly because it would be uneconomical for the bank to not call them. While this is not guaranteed in future, history may provide a degree of expectation that feeds through to the AT1’s market pricing and associated duration risk.  

Corporate Hybrid Bonds are similar in some ways to AT1s but, instead of being issued by banks, they’re issued by the likes of energy companies, utilities, telecoms and pharmaceuticals. They are often issued by investment-grade companies as a more flexible way to borrow and support their credit ratings, as agencies consider hybrids to be part debt / part equity, as the name suggests.  

Just like AT1s, corporate hybrids are senior only to common equity. This subordination factor is what drives their high yield. Issuers have a significant deterrent (via coupon step-up) to encourage them to call the bond on the first call date, generally after five years, which accounts for their low duration.  

Preferred Shares are technically equities, but we can include them in this discussion because they share traits with bonds. In the US, some banks issue Preferred Shares to fulfil similar capital funding requirements as European banks do with AT1s. Preferred Shares are typically from investment-grade issuers and the high yields are driven by their subordination, not the riskiness of the issuer. They are issued either with fixed or variable rates. 

So, again, if you’re concerned about rising interest rates and need to maintain a reasonable level of income, you may want to consider an allocation to AT1s, Corporate Hybrids or Preferred Shares. We have the largest AT1 ETF by some distance², while we are the only ETF provider in Europe to offer focused access to Euro Corporate Hybrids, Preferred Shares and Variable-rate Preferred Shares. 

Correlations³ 

Further innovation in fixed income ETFs 

You can also use ETFs to access innovative exposures in more traditional areas of fixed income. High Yield has long been one of the first ports of call for investors looking to increase credit risk and overall yield, but we believe “fallen angels” could be an even more interesting part of the market as companies and the economy continue recovering from the pandemic. 

Fallen angels are bonds that were investment grade but have been downgraded, usually only by a couple notches, meaning they tend to have higher credit ratings than broad High Yield indices. The bond’s price will usually fall more than it probably should after the downgrade, as passive investment grade products are forced sellers as the bonds drop out of their indices. The bond then has potential to become a “rising star” if it can return to investment grade status. That combination of value, yield pick-up and recovery potential could make fallen angels particularly appealing, especially if you believe the economy or industry outlook will recover.

What happens when a bond is downgraded?  

The first year of the pandemic saw a record amount of fallen angels, substantially more than in the global financial crisis in 2009 or when oil prices fell in 2015-16. Many of the downgrades in 2020 were in the energy and consumer discretionary sectors, which is easy to understand given the effects of lockdown and collapse in oil prices during that year. It is now just as easy to see the recovery potential in those same sectors. In the years following the two earlier events, rising stars dramatically outnumbered fallen angels, and we are starting to see this pattern repeated again now.  

Our Invesco US High Yield Fallen Angels UCITS ETF is the only one in Europe that follows an innovative index that aims to maximise exposure to this potential. It applies a time-weighted methodology whereby it holds full weight in a fallen angel during the price recovery phase and then gradually reduces weight over the next five years as recovery potential erodes. 

ESG demand in fixed income ETFs

We are also seeing increasing demand for ESG within fixed income as investors look to align their full portfolios with their principles. This could be particularly appealing if you want to reduce volatility.  

Fixed income securities with higher ESG ratings experienced lower drawdowns during the particularly volatile period at the beginning of the pandemic. The ratings agencies are increasingly factoring in ESG characteristics into their overall credit rating scores, so, again, that’s just providing a certain level of clarity about future valuations within the fixed income market.

We were the first in Europe to launch a Sterling corporate bond ETF with ESG considerations. ETF investors can gain access to a wide range of fixed income segments with ESG filters applied, not just investment-grade credit but also USD High Yield.