Even in an environment with low rates and high unpredictability, bond exchange-traded funds can serve the traditional roles of income and stability for investors. The trick is finding the right ETFs, said Gene Tannuzzo, deputy head of fixed income at Columbia Threadneedle Investments.

Instead of using passive ETFs supported by broad aggregate bond indexes, or going fully active with their fixed-income allocations, Tannuzzo argues that investors can find both ballast and income potential in multi-sector bond ETFs driven by so-called “strategic beta” indexes.

“Strategic beta designs a balance between credit and liquidity risk to create a more efficient total return,” said Tannuzzo. “It’s different from factor weighting.”

Columbia Threadneedle offers a pair of multi-sector bond ETFs based on strategic beta indexes: The Columbia Diversified Fixed Income Allocation ETF (DIAL) and the Columbia Multi-Sector Municipal Income ETF (MUST). But Tannuzzo, who also oversees a stable of active bond managers in his firm's mutual funds business, describes himself as agnostic regarding active versus passive.

Aggregate bond indexes, like the Bloomberg-Barclays U.S. Aggregate Bond Index, otherwise known as the Agg, fall short for bond investors in several ways, Tannuzz explained. But when it comes to income, it’s their allocation among the major asset classes and sectors of bonds that harms their performance.

“There are three asset classes in [the Agg],” he said. “U.S. government bonds, U.S. agency mortgage-backed securities and investment-grade corporate bonds, which are only 20% of the index. The other three quarters essentially align with government-backed assets that the Fed has made into a policy tool.”

With the Federal Reserve committed to long-term low interest rates and a policy of quantitative easing, funds based off the Agg aren’t likely to offer significant positive real yields to investors. Over the past several days, the yield of the Agg has hovered around 1.5%, said Tannuzzo, who noted that one of the prevailing measures of inflation, the PCE deflator, also comes in at around 1.5%. “After inflation, you get nothing.”

That’s important because the fixed-income market is situated in such a way that the major driver of investor returns will be yields, or the income offered by bonds, which means many fully passive aggregate fixed-income ETFs will offer nothing in the way of real returns.

“The two basic measures of value, Treasury interest rates and credit spreads, are both starting the year at pretty low levels and it’s harder for them to go lower [which would make prices higher],” said Tannuzzo. “The places where we might still see some price appreciation in the bond market, even though we’re starting from elevated prices, are areas that can still recover from specific Covid-19 impacts.”

That would include bonds related to travel and leisure, said Tannuzzo, who identified commercial mortgage-backed securities as a potential area of opportunity for fixed-income investors, as well as areas of the municipal bond markets related to hospitals, toll roads and retirement communities, which were negatively impacted by the pandemic.

He added there might also be opportunities for bond investors in the realm of credit upgrades, as last spring saw a large number of fallen angels, or companies downgraded from investment grade to high-yield territory, within a two-month period.

“Historically, upgrade trends don’t play out in two months, but two years,” Tannuzzo said. “The credit upgrades for companies who have managed their balance sheets well will come late this year or early 2022, and there may be some price appreciation there, but those will be the exceptions, not the rule.”

That means to achieve a real return from their fixed-income allocations, most investors will have to look for sectors and asset classes paying yields above the rate of inflation, but many of the asset class and sector plays available to bond investors in 2020 will no longer work in 2021.

For example, after the market declines at the height of the pandemic last spring, investment-grade credit became extremely attractive for a time but faded as the Federal Reserve became involved in the credit market, said Tannuzzo. Then, investor attention moved to high-yield bonds last summer, which similarly became less attractive as the year progressed and investor attention moved to emerging-market bonds.

“Now as we sit here today, I don’t think there’s a single sector that stands out as cheaper than the rest because liquidity risk premia have condensed,” he said. “I do think there’s some opportunity in a broadly recovering economic environment. You want exposure to credit-sensitive assets to help generate income, but it should be in a more diversified, risk-balanced way. Portfolio construction plays a huge role now.”

It also means that the cost paid for fixed-income funds has become even more critical to the performance of investment portfolios, Tannuzzo said, because other variables impacted the net yield to an end client—such as taxes and Treasury yields—are unlikely to change much over the course of the year.

“A fixed fee or expense ratio is starting to take a much larger proportion of my after-tax income,” he said. “Solutions that are cost-effective have an even more significant impact today than they would in a high-yield, high-spread, low-tax environment.”

That’s where DIAL and MUST come in.

“Both operate on a similar principle that we can generate more yield for a portfolio than a traditional index by expanding the opportunity set,” said Tannuzzo. Managers of both ETFs try to manage tail risk by selecting quality securities and keeping their focus on the more liquid portions of the fixed-income universe.

The $925 million DIAL ETF yields 2.62% and targets six sectors: U.S. Treasurys; U.S. agency mortgage-backed securities; U.S. corporate investment-grade bonds; U.S. high-yield bonds; developed country sovereign bonds ex-U.S. Treasurys and emerging markets sovereign debt. Over three years ending on Jan. 31, this ETF has offered investors 6.62% returns based on net-asset value, according to Columbia Threadneedle. It carries a 0.28% expense ratio.

The $75 million MUST ETF yields 2.18% and targets five segments of the municipal markets: Municipal core general obligations; high-quality revenue; core revenue; healthcare and high-yield. Over three years ending on Jan. 31, the ETF has offered investors 5% returns based on net-asset value, according to Columbia Threadneedle. It carries a 0.23% expense ratio.