Tread carefully in the bond market

Bond exchange-traded funds have given the watchdog cause for concern. Sarah Moore asks why, and what that means for your portfolio.

Bonds have enjoyed a strong bull run for decades now, with prices rising (and yields shrinking) amid falling interest rates, low inflation and central banks whose policies have greatly helped to reduce the number of defaults across the board not to mention the fact that investors have also been rattled by two massive stockmarket crashes within the last 15 years.

There has also been a huge rise in the popularity of "passive" rather than "active" investment in recent years. Put these two trends together and it's little surprise that bond exchange-traded funds (ETF) are proving increasingly popular. In 2014 alone, investors poured a record $81.9bn into bond ETFs, and the pace has continued, "with inflows of $44.3bn by the end of July" this year, reports the Financial Times.

The attractions of these ETFs are clear. They offer a relatively cheap and simple way to get exposure to bonds (government or corporate) as an asset class. And given that individual bonds are generally far harder for private investors to buy and sell than equities, they offer a convenient way to get into the asset class.

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However, it's this apparent convenience that has the Basel-based watchdog, the Bank for International Settlements (BIS often nicknamed the 'central bankers' central bank'), concerned about the recent surge in interest in bond ETFs and other fixed-income funds.

In short, the BIS worries that the accessibility of these funds might have created a "liquidity illusion", whereby investors are confident that they can trade out of their position at any time as promised by bond ETFs when in fact, in the event of an "adverse shift in market sentiment" (the watchdog gives the example of the 2014 "flash crash", which hit the US Treasuries market), the BIS warns it may be much harder than people expect to offload their holdings at least not without the price falling dramatically.

This liquidity issue is something that both fund providers and regulators are keenly aware of. Valrie Baudson, global head of ETFs and indexing at Amundi, argues that it's "vital for investors to look inside' all bond ETFs to understand exactly what they are buying". For example, the biggest bond ETFs will track large indices of bonds of varying liquidity, whereas other funds are more selective in choosing the most liquid bonds.

However, given the overpriced nature of bonds generally, and the risk of rising interest rates, we'd be reluctant to invest big in the asset class at all right now, beyond a holding of the most liquid bonds for asset-allocation purposes.

Sarah is MoneyWeek's investment editor. She graduated from the University of Southampton with a BA in English and History, before going on to complete a graduate diploma in law at the College of Law in Guildford. She joined MoneyWeek in 2014 and writes on funds, personal finance, pensions and property.