After a slow 2022, flows into European bond exchange-traded funds (ETFs) have increased in 2023, with retail and institutional investors returning to long-duration allocations, according to the latest Cerulli Edge―Global Edition.

Globally, fixed-income ETFs posted extremely positive net inflows in the first four months of 2023, surpassing the amount of net new money collected from investors for the whole of 2022.

Although some concerns remain, not least over the liquidity of corporate bond ETFs, there are signs of increased innovation in European bond ETFs, according to the research.

In Europe, demand in the fixed-income sector is currently being driven by institutional investors seeking exposure to specific market segments and anticipating opportunities presented when inflation begins to cool. However, the longer-term growth in the broader ETF market is likely to be driven by greater interest from retail investors.

“Investors expecting a recession later this year are increasing their allocation to duration, with attractive yields on offer. Some are also returning to fixed income as a strategic allocation while waiting for opportunities in the active space,” says Fabrizio Zumbo, director, European asset and wealth management.

Institutional investors are also responding to regulatory requirements to identify more transparent, lower-cost fee structures. Demand for transparency is especially strong in environmental, social, and governance (ESG) products, due to the ongoing misgivings about the robustness and consistency of ESG ratings.

In the retail market, the diversified nature of broad-based, core bond ETF products is more appealing against the uncertain outlook, particularly for investors with a more long-term mindset, notes Cerulli. “Retail flows in 2023 have been strongest in the government and investment-grade sectors, with a strong bias toward quality. There was a marked shift into government allocations in March after the collapse of U.S.-based Silicon Valley Bank triggered a flight to safety,” says Zumbo.

Although the range of fixed-income ETFs in Europe remains relatively limited compared to other asset classes, recent launches show a higher level of specialization in this segment. These include new sovereign bond ETFs, launched in response to increased demand, particularly in the sustainability space. There is also a range of structures available, with high inflation and interest rates driving demand for shorter-duration bonds, expanding the menu of products available for investors

Liquidity concerns did contribute to a contraction in 2022, but Cerulli believes global green, social, and sustainability-linked bond issuance will likely return to growth in 2023. However, ESG remains slightly under-represented in fixed-income ETFs, possibly due to the difficulty of implementing climate-aligned benchmarks into fixed income.

One of the barriers to implementing ESG in the government bond space is the difficulty of securing a material pick-up in ESG or green exposure by using purely government bonds, given the uniformity of regulation in Europe. This is an area where an active management approach to ETFs could work. Using an active approach can enable managers to maintain an allocation to broad benchmarks and go overweight in those, while matching up with characteristics of broad euro sovereign indices.

“The trend toward active bond ETFs is likely to continue, but the downside remains unchanged: although active bond ETFs are cheaper than actively managed mutual funds, the expenses are higher than on pure passive bond ETFs,” says Zumbo.