In Times of Crisis
2022 has been characterized by unstable geopolitical dynamics which have spilled over into the real economy via commodity prices. From this trigger, instability has spilled onto financial markets. According to Florian Cisana, Head UBS ETFs & Index Funds Strategic Markets Nordics, France & Israel at UBS AM, investors have been looking for products that provide safety, hedges and decreased duration to tackle these new contingencies via the fixed income ETF and passives market.
Given these trends, Cisana expect the sustainable fixed income ETF and passives market to continue to grow in response to demand from clients.
Current Market Environment
The shift from a low to a high inflation regime witnessed this year has led to a parallel shift in interest rates. “In 2022 we have witnessed an inversion of the low-interest rate environment that had established itself in recent years. In order to battle inflation major central banks increased their reference rates and generally put an end to their extremely loose monetary policies. This shift resulted in a higher starting point of risk-free rates, which substantially improved the return profile for coupon-bearing assets (e.g. government bonds and credit) with expected return now being positive,” says Cisana.
“Thanks to the switch from low interest rates to the current rising rates environment, we have seen clients driving back demand into fixed income ETF. Given the improvement on expected returns we also foresee fixed income ETFs to increase in importance within clients’ portfolios, not only for diversification purposes but also from a pure risk-return perspective,” he adds.
The move from a context of low rates to a higher rates environment also changed investor demand in 2022, when compared to previous years. “In particular, we noticed a shift from riskier exposure to relatively safer options within the fixed income market. One driver of this change was surely the risk-off mood that dominated 2022 but, in addition to that, another factor for this shift has been the higher interest rates environment,” Cisana argues.
“In order to harvest an acceptable yield, clients no longer need to invest in the riskier parts of the fixed income market (e.g. high yield, EMD), because now credit and government bonds offer attractive yields on an absolute basis. As shown in Exhibit I, this shift resulted in additional demand for ‘Government’ and ‘Corporate’ funds both in USD and EUR denominated debt, and outflows in riskier segments like ‘High Yield’,” he explains.
One additional trend in ETF demand we noticed in 2022 is the increase interest toward currency hedged products, according to Cisana. “In a year like 2022, where currency volatility rose to historically high values and the USD appreciated significantly against all the major currency pairs, clients realized the importance of understanding and managing the currency risk of their portfolio. In this regard, many clients became less prone to taking currency risks, and opted for the currency-hedged version of the ETFs.”
Exhibit I: YTD Flows UCITS ETFs by segmentsESG Fixed Income ETF demand vs non-ESG
“Inflation and rising rates have been the elephant in the room in 2022, and a lot of attention was put on how these variables impact the performance of the various fixed income segments,” Cisana argues. “When looking at how these trends have impacted the integration of sustainability it is interesting to note how, as shown in the figure below, sustainable ETFs have been constantly in demand even in a challenging year like 2022,” he continues.
“As the next figure shows, there has been a large tactical shift in the non-ESG exposure, which signals how the ‘core’ fixed income ETFs are the instruments used by clients to reflect their tactical views, but ESG ETFs were less impacted by these tactical moves,” Cisana says. “This could potentially prove that clients are not willing to compromise their ESG-values despite market conditions, and the sustainability integration continues regardless of the market sentiment,” he adds.
Portfolio Mitigation of Rate Hikes
Due to a combination of the pandemic measures, supply chain shocks and the Russia-Ukraine conflict, central banks had to try to control an inflation not seen in the last four decades by increasing policy rates. “With inflation reaching these historical levels, global central banks shifted to tighter monetary policies and implemented rate hikes,” Cisana explains.
“Given this environment, in 2022 many of our clients have been looking for instruments to shorten the duration of their portfolios. In order to satisfy this demand, in 2022 UBS ETF launched two new strategies targeting the short part (1-5 Years) of the US and Euro credit market, with a sustainability overlay,” he adds.
According to Cisana, these two new strategies give clients the opportunity to reduce the duration of their corporate exposure while aligning with their sustainability objectives. “These new products complete our existing UBS ETF Fixed Income shelf where, as one of the key principles, we allow clients to tactically play duration offering funds with different maturity buckets, across Corporates and Treasury, Developed Markets or Emerging Markets, sustainable or standard,” he says.
The Intersection of ESG and Traditional Fixed-Income?
Unstable conditions often drive investors to safe haven assets. The ongoing crisis has not been an exception. “In many client’s fixed income portfolios, the Sovereign part is usually the largest component. In this regards we have seen growing demand for sustainable products and, over the years, we expanded our UBS ETF offering in this space,” Cisana explains.
“A first example of an interesting solution found at the intersection of ESG and fixed-income is our ETF tracking the J.P. Morgan Global Government ESG Index. Such index offers a broad exposure to sovereign bonds, while excluding issuers that have a ESG Score below a certain threshold and reweighting the remaining constituents in order to increase the weight of issuers with high ESG Score. The aim of this exposure is to have an index with similar risk-return properties as the Global Government Index, but with improved sustainability characteristics,” Cisana argues.
Exhibit II: YTD FI Inflows in UCITS ETFs
“An additional example of an interesting ESG fixed-income solution is our Sustainable Development Bank Bonds ETF. This fund tracks a Solactive index which targets bonds issued by Multilateral Development Banks (MDBs). It offers a unique sustainable investment opportunity because the capital raised through these bonds is used by development banks to fund high impact development projects in developing countries. Thanks to their unique capital structure and because they are backed by G7 countries, MDBs receive a very high credit rating, making them a candidate for the safest part of the portfolio. MDBs can be considered a liquid and low-risk form of impact investing, and can be seen as a sustainable alternative to US Treasuries,” he adds.
Selecting FI ESG Index Providers
Indices are at the core of fixed income ETF products, and their reliability is crucial according to Cisana. “When selecting index providers in the Fixed Income ESG space our key focus is to be confident in their sustainable approach as well as ensure that the fixed income index can be replicated by the ETF.”
“When looking at fixed income indices, UBS ETF approach has always been to incorporate certain liquidity criteria directly in the index construction. This ensures lower turnover, better liquidity and makes the benchmark more easily trackable. In this sense, when working with index providers on new sustainable Fixed Income solutions, we not only analyse the ESG data coverage, reporting capabilities and ESG data quality, but always keep and eye on how to merge the sustainability considerations with the liquidity criteria,” he continues.
“A prime example in this regard is our Liquid Corporate Sustainable ETF range that track Bloomberg MSCI indices. In this family of exposures we leverage MSCI ESG data along with the Bloomberg customized liquidity criteria that characterize our UBS Liquid Corporates offering,” Cisana says.
The Path Ahead
“In recent years we have seen how the role of ETFs in the Fixed Income part of a client’s asset allocation is expanding a becoming more predominant. Within the category of fixed income ETFs, sustainable funds are clearly on the rise,” Cisana says.
“This led to an increase in the share of AuM of Sustainable Fixed Income ETFs which now stands at 18% of the total Fixed Income ETF assets. Considering that clients are becoming more and more aware of the importance of integrating sustainability in their allocation, we expect this trend to continue in the future,” Cisana concludes.