Michele outlines six structural considerations shaping how fixed income is implemented through active exchange traded funds.
Duration is the first. “Active fixed income ETFs give managers the flexibility to set interest rate sensitivity (duration) and yield curve stance as conditions change, rather than simply matching an index,” he says. Managers can emphasise sectors and structures with more stable convexity, such as carefully selected agency MBS and CMO profiles, to help manage rate moves through phases like a Fed hiking/cutting cycle and potential curve steepening/flattening.
Security selection follows. “Security selection is key to active construction,” Michele says.
Managers can be selective about lower quality segments and avoid weaker issuers that pose higher default risk. In securitised credit, deal level research and underwriting allow managers to target issues that offer attractive spreads.
Sector exposure can also be adjusted. “Active ETFs let managers rotate among Treasuries, investment grade and high yield credit, and securitised assets as growth, inflation, and valuations change,” Michele says. When defensive ballast is required, he says managers can lean into higher quality sectors. When compensated for risk, they can add spread sectors to boost carry.
Benchmark design itself shapes portfolio opportunity. Michele says popular bond benchmarks omit or under-represent areas such as high yield and large parts of the securitised universe and can miss many municipal opportunities. Active fixed income ETFs can extend beyond those constraints and incorporate these segments.
Within sectors, structure matters. Managers can choose specific bonds and collateral profiles, including bank capital securities such as AT1s and CoCos, with the aim of improving return efficiency and stability versus index exposure.
Risk allocation runs across these decisions. “Active construction makes risk intentional, not incidental,” Michele says. Managers can limit concentrations, including avoiding overexposure to the most indebted issuers in capitalisation weighted indices or to single issuers, and allocate risk across duration, curve, credit and securitised exposures.
Liquidity remains the defining constraint in bond markets. Unlike equities, which trade on centralised exchanges with continuous price formation, bonds trade over the counter across millions of individual securities.
Jo Cornwell, head of manager research at Evidentia Group, says that structure produces uneven liquidity.
“Bonds trade over the counter across millions of individual securities, with liquidity concentrated in certain issuers and maturities,” she says. “In periods of stress, that liquidity can fragment quickly and bid offer spreads can widen materially.”
She says bond market liquidity depends heavily on dealer balance sheets, which can contract during stress. That makes vehicle selection important when accessing fixed income exposures.
Fragmented trading also complicates price discovery. Cornwell says there is no single central price for many bonds, creating uncertainty around fair value in volatile markets. Exchange traded vehicles can assist price discovery because they aggregate underlying exposures and trade continuously, offering a real time reference point. She says investors still need to understand the holdings beneath the structure.
Ryan Szakacs, head of ETF capital markets group J.P. Morgan Asset Management says the ETF wrapper adds another layer. Szakacs says ETFs trade on exchanges where investors can buy or sell shares at readily available prices throughout the day. Every dollar traded that does not flow into the primary market is considered additional liquidity.
Szakacs points to data from US high yield ETFs. “When looking at the top 10 US high yield ETFs, approximately 13 per cent of their volume led to primary market flows,” Szakacs says. During periods of inflation concerns in 2022 and 2023, he says secondary market trading of the US high yield ETF market represented nearly 50 per cent of the total US high yield trading volume, while primary volume from these ETFs represented less than 10 per cent of the total US high yield market volume.
Szakacs says that during periods of market stress, bond ETF spreads have been significantly tighter than basket spreads, including during the COVID 19 pandemic. Trading volume in ETFs increased during these periods, while it declined in the high yield bond market. He says ETFs acted as a price discovery mechanism.
Secondary trading can reduce turnover in the underlying portfolio. Based on trading data for high yield funds over a nine-month period ending September 2024, Szakacs says only approximately $1.30 out of every $10 transacted on exchange resulted in a flow to the primary market in the form of a creation or redemption. He says this means that 13 per cent of investor trading activity in the ETF wrapper led to trading by the portfolio manager, and that this percentage is often reduced further during market stress.
Cornwell cautions against equating daily pricing with guaranteed liquidity. “In reality, liquidity is about the ability to transact at a reasonable cost, particularly under stress,” she says. She adds that government bonds, investment grade credit and securitised assets have distinct liquidity profiles, and that structure and portfolio construction influence how those exposures behave.
Institutions are weighing how liquidity, cost and flexibility interact within fixed income portfolios. Michele says ETFs have become prevalent in modern investment portfolios due to their flexibility and liquidity, combining secondary market trading with the primary market creation and redemption mechanism.
“While trading ETFs can be simple, there is no one size fits all approach, so maintaining an open dialogue with the trading experts at ETF issuers as you seek liquidity is essential,” he says.
He says that globally, 85 per cent of fixed income assets in mutual funds are actively managed but only 17 per cent of fixed income ETF assets are actively managed. Approximately 33 per cent of fixed income ETF flows globally and about 40 per cent of the flows in the US through October have gone into active strategies.
In bond markets defined by fragmentation and shifting dealer balance sheets, structure shapes outcomes. How liquidity behaves under pressure, and how portfolios are built around that reality, now carries weight equal to the allocation itself.
To find out more, please visit J.P. Morgan Asset Management.