Despite the bond market being bigger than the equities market, bonds mostly trade over-the-counter (OTC) and not on any centralized exchange. In fact, traders mostly swapped bonds over the phone, negotiating prices and making deals. However, this “old school” approach came with several disadvantages, including high transaction costs, illiquidity, and a lack of true transparency in the market.
A New Way to Play
Today’s infographic comes to us from iShares, and it shows that over the last two decades, the bond market has been dramatically transformed and democratized from the “old school” approach that relied on phones, traders, and giant bond calculators. The biggest factor in this transition: the use of exchange-traded funds (ETFs) in the bond market, which just hit a new global milestone of $1 trillion of AUM in June 2019. Let’s look at the journey of how this rapidly rising segment of the market took off, the factors driving it, and what the future may hold for Bond ETFs.
Bond ETFs: Journey to $1 Trillion
Below is a year-by-year account of new innovations in bond ETFs, and how the usage of them has changed over time: 2002: New tech A new financial technology, the ETF, shakes up the bond market for the first time – and the first fixed income ETFs launch in the United States. 2003: More variety Just one year in, and there are already numerous types of bond ETFs that allow investors to fulfill different portfolio needs:
Government bond ETFs TIPS ETFs Corporate bond ETFs Aggregate bond ETFs
2006: Achievement unlocked The global bond ETF industry hits $25 billion in AUM. 2007: Bond ETF innovations The bond ETF universe continues to expand as investors demand even more options:
Mortgage-backed security bond ETFs Muni bond ETFs High yield bond ETFs
2008: A new source of liquidity Liquidity for individual bonds dries up during the 2008 Financial Crisis. However, bond ETFs step up to the plate by providing a new source of liquidity and volume increases, allowing investors to efficiently access fixed income markets. 2010: More precise strategies The first term-maturity ETFs launch. These special bond ETFs specifically hold bonds that all mature in the exact same year. 2012: Achievement unlocked The global bond ETF industry hits $250 billion in AUM. 2015: More product innovation At this time, factor-based bond ETFs start to hit the mainstream. These use a rules-based approach to employ multiple investment factors, such as low volatility, quality, value, or momentum. 2016: Achievement unlocked The global bond ETF industry hits $500 billion in AUM. 2017: Green bonds Green bonds ETFs provide investors with the ability to invest in bonds that are tied to sustainability purposes. 2018: Market volatility and bond ETFs In the second half of 2018, markets get volatile and investors turn to bond ETFs to help reduce their overall portfolio risk, specifically diversifying their exposure to stocks. 2019: Achievement unlocked The global bond ETF industry hits $1 trillion in AUM, with now over 1,300 bond ETFs available.
The Path to $2 Trillion?
In just 17 years, bond ETFs have grown to be a significant part of the investment universe, reaching $1 trillion AUM in 2019. Impressively, it won’t likely take long to double the last milestone. According to BlackRock, it’s anticipated that ETFs will hold $2 trillion in AUM by the year 2024 — just a few short years down the road. on Last year, stock and bond returns tumbled after the Federal Reserve hiked interest rates at the fastest speed in 40 years. It was the first time in decades that both asset classes posted negative annual investment returns in tandem. Over four decades, this has happened 2.4% of the time across any 12-month rolling period. To look at how various stock and bond asset allocations have performed over history—and their broader correlations—the above graphic charts their best, worst, and average returns, using data from Vanguard.
How Has Asset Allocation Impacted Returns?
Based on data between 1926 and 2019, the table below looks at the spectrum of market returns of different asset allocations:
We can see that a portfolio made entirely of stocks returned 10.3% on average, the highest across all asset allocations. Of course, this came with wider return variance, hitting an annual low of -43% and a high of 54%.
A traditional 60/40 portfolio—which has lost its luster in recent years as low interest rates have led to lower bond returns—saw an average historical return of 8.8%. As interest rates have climbed in recent years, this may widen its appeal once again as bond returns may rise.
Meanwhile, a 100% bond portfolio averaged 5.3% in annual returns over the period. Bonds typically serve as a hedge against portfolio losses thanks to their typically negative historical correlation to stocks.
A Closer Look at Historical Correlations
To understand how 2022 was an outlier in terms of asset correlations we can look at the graphic below:
The last time stocks and bonds moved together in a negative direction was in 1969. At the time, inflation was accelerating and the Fed was hiking interest rates to cool rising costs. In fact, historically, when inflation surges, stocks and bonds have often moved in similar directions. Underscoring this divergence is real interest rate volatility. When real interest rates are a driving force in the market, as we have seen in the last year, it hurts both stock and bond returns. This is because higher interest rates can reduce the future cash flows of these investments. Adding another layer is the level of risk appetite among investors. When the economic outlook is uncertain and interest rate volatility is high, investors are more likely to take risk off their portfolios and demand higher returns for taking on higher risk. This can push down equity and bond prices. On the other hand, if the economic outlook is positive, investors may be willing to take on more risk, in turn potentially boosting equity prices.
Current Investment Returns in Context
Today, financial markets are seeing sharp swings as the ripple effects of higher interest rates are sinking in. For investors, historical data provides insight on long-term asset allocation trends. Over the last century, cycles of high interest rates have come and gone. Both equity and bond investment returns have been resilient for investors who stay the course.
