The resilience of the US economy has pushed bond yields higher in recent months © Gabby Jones/Bloomberg

Investors have been flocking to fixed income exchange traded funds to scoop up higher yields this year, despite a broad sell-off in bonds, as markets brace for interest rates staying higher for longer. 

Fixed income ETFs listed across the US and Europe attracted a record $235bn of net inflows in the first three quarters of this year, according to data compiled by BlackRock, up from $169bn in the same period last year and $222bn in the first three quarters of 2021.

This trend continued in October with net flows of $13.4bn in the first 13 days of the month, despite a wider fixed income sell-off as investors prepare for persistently higher interest rates. Analysts say that fixed income ETFs had attracted flows owing to the attraction of the higher yields on offer, as well as the vehicles’ increasing popularity as investment tools and their growing use within model portfolios.

“There’s a lot of interest in fixed income ETFs at the moment, given they are a great way to get easy access to an asset class that is becoming ever more attractive in yield on offer,” explains Ben Seager-Scott, head of multi-asset funds at Evelyn Partners. 

However, the relentless rise of yields has pushed prices down and left investors who own bonds with long-dated maturities nursing heavy losses. An iShares ETF which owns Treasuries with a maturity date of 20 years or longer is down by 12.9 per cent this year. 

“The sell-off since the summer wrongfooted many investors, but for . . . investors [with a longer time horizon], these levels may have still been attractive,” says Antoine Lesne, a managing director at State Street.  

Prices have fallen as central banks maintain the fastest pace of interest rate rises in a generation. Since early 2022, the Federal Reserve’s funds target rate has risen by more than 5 percentage points, to a range of 5.25 to 5.5 per cent.

Yields have been propelled in recent months by the unexpected resilience of the US economy, which has made investors realise that interest rates are likely to stay higher for longer. Concerns over the amount of debt governments plan to issue in the year ahead, at the same time as central banks look to reduce their balance sheets, has also pushed government bond yields up.

The majority of fund inflows on both sides of the Atlantic have been into sovereign debt ETFs with high credit ratings. US Treasury ETFs pulled in just in excess of $100bn in the year to October 9.  

Products that own debt with short-dated maturities have attracted the lion’s share of these flows. In the US, the yields of such ETFs have been higher than their longer-dated counterparts, as investors have been pricing in that interest rates will start to fall next year. 

“Because short-term rates have been much higher than longer-term rates it makes sense that investors have focused on one-to-three month ETFs,” says Rohan Reddy, director of research at fund manager Global X. The trend reflects a broader surge of capital into money market funds this year from investors seeking an alternative to cash. 

But flows into ETFs holding longer-dated bonds have also been healthy this year, despite large price falls, as investors have increasingly bet that interest rates would stay higher for longer. Data from TrackInsight shows that iShares’ 20+ years Treasury Bond ETF has been the best selling fixed income ETF this year, attracting $17.9bn in the year to October 18.  

And, in spite of the recent poor performance of fixed income products, strategists expect investors will continue to put money into them, as the asset class is under-owned following years of interest rates at rock-bottom levels. 

“I think we are at the early stages of a reallocation to fixed income,” says Brett Pybus, global co-head of iShares fixed income ETFs for BlackRock. “Our analysis points to an average increase of 10 per cent in fixed income allocations across client portfolios in Europe, the Middle East and Africa,” he adds. 

However, as the impact of higher global interest rates starts to feed through, investors are being more cautious about jumping into high yield ETFs because the risk of default has been rising, with companies increasingly forced to refinance at much higher interest rates.  

“I think high yield is an area to avoid at this stage of the cycle, but there will be a time when they are attractive again,” says Evelyn Partners’ Seager-Scott. TrackInsight data shows that high yield ETFs had net outflows of $1.3bn in the year to October 2, compared with inflows of more than $200bn for investment grade counterparts. 

Some investors are opting for ETFs that own index-linked government bonds, to lock in returns ahead of inflation.  

“From our vantage point, investors have been putting inflows into Treasury floating rate notes,” says Kevin Flanagan, head of fixed income strategy at WisdomTree. “Treasury Floating rate notes carry only one week in duration and are essentially one of the highest yielding Treasury securities”.

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