Bond boom

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  By Guest Blogger Doug Rowat

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In May of last year, BlackRock forecast that the global bond ETF market would reach US$5 trillion in assets by 2030. With global bond ETF assets currently sitting at only about US$1.7 trillion, a tripling of asset size in less than a decade was a bold prediction.

Its prediction, unfortunately, took a credibility hit just a few months later when its own flagship bond ETF, the iShares Core US Aggregate Bond ETF, lost its status as the world’s largest bond ETF to rival Vanguard with its Total Bond Market ETF. However, this bit of bad timing aside, BlackRock’s 2030 bond ETF forecast is still, we believe, likely to be accurate.

Why is the bond ETF space poised to grow so dramatically?

First, bonds, for the first time in years, are finally providing attractive yields. Generally speaking, the initial yield on a bond (or a portfolio of bonds) provides a pretty reliable indicator of future returns. And these potential returns are becoming compelling. The yield on a US 10-year Treasury, for instance, basically the safest investment on planet Earth, is 4x higher than it was just two years ago (3.71% versus 0.93%). And I’ve highlighted before that a negative year for bonds often signals several years of strong subsequent returns (see table below). Naturally, higher yields and the promise of attractive total returns supports expansion of the bond ETF market.

US Investment Grade Bond Index forward returns following negative-return year

Click to enlarge. Source: Invesco; annualized total returns

Second, bond ETFs are a relatively new invention, but already have an exceptional growth record. iShares introduced the first bond ETFs just 20 years ago and in this relatively short period the market has grown 23% annually to, as mentioned, US$1.7 trillion, now divided amongst more than 1,400 ETFs. Reaching US$5 trillion in assets by the end of the decade means that only a 14–15% annualized growth rate would be required. Ambitious to be sure, but feasible.

Actual and projected global bond ETF assets (US$ billions)

Source: BlackRock

Third, bond ETF penetration of the overall fixed income market remains miniscule. The total US fixed income market, for example, sits at about US$53 trillion. However, US fixed income ETFs hold less than a 2% market share. US equity ETFs, by comparison, hold nearly a 10% share of the aggregate US equity market. In other words, bond ETFs are presented with a large opportunity.

Fourth, and related to the above point, bond ETFs carry all of the advantages of equity ETFs making the bond ETF under-penetration unjustified. Like equity ETFs, bond ETFs provide diversification and greatly reduce individual issuer risk (in the case of bonds, mainly default risk). Like equity ETFs, bond ETFs are also liquid and low cost. Individual emerging-market bonds, as one example, can be 60x more expensive to trade than an ETF tracking an emerging-market bond index. And the Vanguard Total Bond Market ETF mentioned above, which is now the world’s largest? Its MER is only 0.03%. Incidentally, it also forced the iShares Core US Aggregate Bond ETF, the ETF it overtook for top spot, to lower its own fee to keep pace.

Finally, investors always want more product variety. Whether it’s something as simple as floating-rate bond ETFs, which were certainly desirable last year, or more granular corporate-bond products that focus on specific sectors or industries, the demand for more robust bond ETF offerings, as with equity ETF offerings, will continue to grow.

A bigger marketplace almost always provides advantages for investors. Lower cost, better product selection, improved liquidity and so on. We already know how these advantages have contributed to a wave of equity-ETF asset growth.

Now it’s time for bond ETFs. A new wave is upon us.

$    $    $

Finally, despite the current chaos in the US House of Representatives, 2023 is shaping up to be a calm political year. For the first time this century, no G7 country will experience a major election:

Major elections for G7 countries: 2023 a stable political year?

Source: Deutsche Bank; *assumes future elections are held on the last day possible

In other words, politically speaking, this should be a relatively stable year. Just don’t tell that to Kevin McCarthy.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Investment Advisor, Private Client Group, Raymond James Ltd.