By Virginia Munger Kahn

Fixed income exchange-traded products (ETPs) have been the fastest growing segment of the global exchange traded industry for 10 years, but 2012 is likely to break new records for cash inflows, according to Dodd Kittsley, global head of ETP Research at BlackRock, the largest manager of ETPs with $482 billion in assets under management. That includes $184 billion in fixed income ETPs.

Through mid-September, fixed income ETPs attracted $51.7 billion in net new flows, which is ahead of the pace set during the previous record year of 2009 when flows reached $45.4 billion by the end of Sept., according to BlackRock.

This year's flows build on a period of rapid growth for ETPs (exchange-traded funds and exchange-traded notes) in general and fixed income ETPs in particular. During the past five years, assets in fixed income ETPs have expanded at a 43% compound annual growth rate and they now comprise 18% of global ETP assets versus 7% in 2007.

Equity ETPs, which includes real estate, have grown 11.2% annually during that period, while commodity ETPs have grown 41.6% annually.
The strong flows are a "continuation of the strong growth we've seen in fixed income ETPs in the last five years," says Kittsley. "We don't see any signs this growth is abating. If anything we see the trend accelerating."

In a report on the ETP landscape issued in August, BlackRock predicated that global fixed income ETP assets will grow to more than $1 trillion in the next five years and $2 trillion in 10 years. "We are just scratching the surface of investor adoption," says Kittsley, the report's author.

The surge in assets in fixed income ETPs reflects investors' desire for safety and income after 12 years of subpar stock market returns and heightened volatility. This focus on stability and income has been particularly noticeable since 2008, as assets in bond mutual funds have surged to almost $3 trillion.

But the interest in bond ETPs also reflects longer-term trends, including the aging of the investor population and the traditional move by people in or nearing retirement to increase fixed income allocations. In addition, as investors have become more familiar with the ETP structure and with the benefits of ETPs, they have put more money to work in these vehicles, says Kittsley.

The ETP Appeal
One of the key benefits is the ability to access typically illiquid markets through a highly liquid investment vehicle. "ETPs take the over-the-counter market in bonds--where bonds often trade in negotiated deals--and add liquidity and price transparency," says Kittsley. This is changing the way investors are getting exposure to the fixed income markets. It's more economical for a global hedge fund to access emerging markets through ETFs than by buying all the securities, Kittsley noted.  

Given these benefits and the value they provide investors, BlackRock sees three particularly good growth opportunities for ETPs--investment grade corporate bonds, high-yield bonds and municipal bonds. The municipal bond market holds promise for good growth given current low ETP penetration rates and the benefits ETPs can bring investors in this notoriously opaque and illiquid market, said Kittsley. Other segments that hold promise for growth are global bonds and managed and wrap ETP solutions.  

The primary risk in BlackRock's scenario is rapidly rising interest rates. When the Fed began a 25-month campaign to raise interest rates in 2004, bond mutual funds saw $10.7 billion in outflows. However, bond ETPs have weathered more recent--albeit shorter--periods of rate increases better. Between year-end 2008 and 2009, fixed income ETPs attracted $60 billion in cash even as the rate on the 10-year U.S. Treasury bond rose 160 basis points.

"That year, 2009, was incredibly interesting," says Kittsley, "It showed that flows can be quite robust in an environment that is not the most favorable to fixed income securities."  

He attributes that resilience to the availability of products that allowed investors to weather the rise in rates. That includes Treasury Inflation Protected ETPs, which attracted significant inflows that year. He argues that investors now have more ETPs to combat adverse rate environments, such as very short duration, high-yield and emerging market sovereign debt ETPs.

On The Path
But Avi Nachmany, director of research at Strategic Insight in New York, cautions that passively-managed ETPs could be particularly challenged in a rising rate environment. He says it will be difficult for any bond fund that's captive to an index and is generating negative returns to attract positive cash flows.

In that environment, he notes, investors will want more flexible bond funds. Given the success of the PIMCO Total Return ETF, which has gathered $2.5 billion in assets since its February launch, Nachmany predicts other fixed-income specialist firms will introduce more actively-managed fixed income ETPs. "Actively-managed ETPs will be critical in coming years," he said.

Kittsley, however, is lukewarm on the outlook for actively-managed fixed income ETPs. He says there is room for active strategies, but they are still "incredibly small" in terms of assets under management. "The jury is still out on whether ETPs are the right vehicle for active strategies," he says.

Morningstar ETF analyst Tim Strauts agrees investors will see plenty more innovation in the future. Unlike the mutual fund industry where numerous funds vie for investor dollars in the same category, he expects ETP sponsors to continue to slice and dice the fixed-income world into increasingly fine investment products.

That gives investors more opportunity to tailor portfolios to their specific needs and weather adverse market conditions. If interest rates do rise rapidly, ETP assets would not grow as quickly, says Strauts. But, "the path [to $1 trillion in fixed income ETPs] is clear. It's just a question of when."