The period of extremely low interest rates since 2007 has seen a generation of young investors grow up with an investment culture focused on equities and in particular tech stocks.
A broad range of market participants, and in particular younger investors, surfed the period using aggressive equity-based strategies. The exchange-traded fund industry followed the trend, providing innovative solutions focused on equities. In the ETF universe, the range of bond funds on offer often lagged that of equity trackers.
Over the course of 2023, we have seen the start of what we expect to be the return of fixed income to its rightful place. But you ain’t seen nothing yet!
At the start of the year, there was much talk of 2023 being the year of the bond. In retrospect, it was a little early. Central banks had more work to do in containing high inflation and financial markets were still pricing a new paradigm with quantitative tightening replacing quantitative easing. This process is now well engaged and fixed income is very much back in play.
ETFs – An essential part of the fixed income investor’s toolkit
Index investing has, in our view, a major role to play in translating the broad and often fragmented fixed income investment universe into standardised exposures. These give investors access to those fixed income segments and risk profiles that fit their strategic asset allocation objectives. This is particularly important as bond markets reprice and dance to the tune of market fundamentals rather than those from the central banks.
Our data suggests 2023 flows into ETFs through October were split almost equally between equities and fixed income with almost 400 new fixed income ETFs created globally in 2022-2023, of which 68 in Europe. For the same period, the number of the new fixed income ETFs integrating sustainability criteria was 59 globally and 34 in Europe.
We believe that expansion and innovation in bond ETFs will continue to benefit from a double push via the catch-up with resurging client interest in interest rate products and remarkable growth and innovation in the global ETF industry.
Now is the time for ETF investors to look at bonds
The biggest story in financial markets in the third quarter and through to the end of October 2023 was the unrelenting rise in the yields of US and German government bonds with maturities of 10 years or more. The US 10-year yield, at the heart of asset valuations within the financial system, surged to reach 5%, up from 3.80% at the start of the summer. It’s the first-time yields have been this high since 2007.
Rising long-term bond yields came on the heels of the unprecedently rapid and substantial tightening of monetary policy implemented by the US Federal Reserve (the Fed) and European Central Bank (ECB) as they scrambled to rein in the post-pandemic runaway inflation.
Exhibit 1: Bond risk premia exceed equity premia for the first time since the Global Financial Crisis (The chart shows the S&P 500 earnings yield (next 12 months) versus a bond proxy (30-year US Treasury yield + USD BBB option-adjusted spread).
Starting in the spring of 2022, the Fed and the ECB raised their key interest rates by 525bp and 450bp respectively. For now, they are on hold. But, having been bitten once by the inflation bug, they will not be inclined to lower their guard and cut policy rates until they have inflation well under control. Higher for longer is their new credo.
Bond markets return to normality….
Since the spring of 2022, investors have been through an abrupt and brutal rebooting of the global bond market, taking us back to the level of interest rates that prevailed prior to the Global Financial Crisis of 2007/2008.
While the pace of rising bond yields is startling by historical standards, the actual level is not. On the contrary, during most of the 20th century, a 4.5% yield on a 10-year US Treasury bond was considered normal, if not benign. What is most bizarre today, from a long-term perspective, is not that yields are rising, but that they were so low during the past decade.
An overshooting of bond yields?
With bond yields at today’ levels, we are of the view that yields may have overshot, making fixed income securities potentially attractive — after this exceptional sell-off.
One of the most striking (and surprising) developments in the third quarter of 2023 was a significant rise in US real yields. Exhibit 2 shows just how far the 5, 10 and 30-year benchmark yields have risen both since the Fed began tightening policy in March 2022, and in a broader historical context.
Our view is that the US Treasury nominal and real yields have overshot to the upside. Yields capitulated higher due to a combination of factors, including:
- US growth continuing to surprise to the upside
- Guidance from the Federal Open Market Committee that policy rates would be higher for longer, and that recession risk in the US was receding
- Concerns over larger-than anticipated fiscal deficits leading to heavier longer-dated Treasury supply, as indicated in the Treasury’s July Quarterly Refunding announcement (the refunding announcement on 30 October was more reassuring)
- Quantitative tightening
- Stretched overweight duration positioning among asset managers who had positioned for a US recession in 2023.
Our view is that the conditions for a topping-out of yields are now in place. Tighter monetary policy should start to make itself felt, slowing US and European economies and encouraging flows out of other asset classes and into government bonds. A period of consolidation may be necessary along with a decline in volatility, but the absolute level of valuations represent, in our view, attractive entry levels.
Eurozone bonds stand out for us
The sharp rise in eurozone sovereign bond yields seems to us particularly hard to justify. The eurozone economy may well experience a mild recession in 2023 and will hardly grow by our estimates in 2024. Another external shock could easily tip the region into a deeper recession. Europe has faced a similar increase in policy rates as the US, and a bigger jump in energy prices, but without the massive fiscal stimulus that put the vroom back into the US economy.
Despite the very divergent prospects for growth, the yield of the 10-year German Bund has risen to close to 3%. Investors have, in our view, overreacted to fears that inflation might stay high. Recent data suggests the rate of inflation in the eurozone may decelerate more rapidly than in the US; in other words, the peak in eurozone inflation is clearly behind us. We see a significant risk that the ECB pursues a hard line, keeps policy rates high, exacerbating downside risks.
Integrating environmental, social and governance criteria into bond ETFs
The increasing granularity of ETFs allows ESG investors to redefine their desired market exposure and understand the factors generating risk and return. They allow investors to take control of their fixed income allocations and ensure they reflect the desired ESG criteria.
At BNP Paribas Asset Management, we incorporate a framework to navigate and incorporate ESG criteria into our investment process for indexed investing. We look for index rule books that are aligned as closely as possible to our Responsible Business Conduct policy. We monitor and engage with index providers to adjust the methodology when we identify substantial discrepancies.
Index providers for our bond ETFs integrate proprietary ESG scores that are calculated using data from industry-leading data providers , for over 170 sovereign and 6 800 corporate and quasi-sovereign issuers. The score typically measures an issuer’s ESG performance and subsequently determines its weight in the benchmark.
Index providers apply negative screening for issuers involved in thermal coal, oil sands, weapons and tobacco, as well as issuers that violate the United Nations Global Compact (UNGC). The methodology may assign an overweight to green bonds to incentivise sustainable financing aligned with climate change solutions.
Last, but by no means least, BNP Paribas Asset Management’s dedicated sustainability centre leads the ESG research effort for all our investment teams. Our stewardship team is recognised for its commitment and engagement. Within our fixed income investments, we believe the size of our holdings in corporate debt give us a voice with investee companies. We engage with issuers encouraging them to improve their sustainability practices, then tracking their progress and drawing the necessary conclusions as to their fit with our ESG policies.
As the regulations evolve, they may give a new momentum to sustainable investing by identifying with high granularity the principal adverse impacts on sustainability factors. We view this as an opportunity to capitalise on our in-depth understanding of these new sustainability-related requirements, and to innovate with a completely new offer of fixed income ETFs to be launched in 2024 which will apply our in-house ESG expertise to a non-ESG broad bond universe.
In 2024, we expect investors to further expand their fixed income allocations via index investing. Index investing enables investors to take positions rapidly and efficiently in those segments of bond markets where they see opportunities while considering ESG objectives.
By translating the vast, but fragmented global bond market into standardised and efficient exposures, ETFs can greatly simplify the construction and implementation of bond allocations. We foresee an expansion in the range of fixed income indices, index funds and ETFs enabling a new generation of investors to allocate precisely and flexibly while including ESG criteria. The result will facilitate customised and nimble moves and allocations between segments with scope to adjust efficiently taking advantage of opportunities as the macroeconomic environment evolves and market fundamentals reassert themselves.
ETFs are a means to implement a fixed income strategy in all sectors of the bond universe rapidly and cost-effectively. For these reasons, we believe that fixed income indexing will expand further, reasserting its role as a core element in investors’ portfolios.