ETFs For Fixed Income Liquidity


By Sean Cunningham, Head of Capital Markets for iShares and Index Investing APAC, BlackRock

Exchange Traded Funds can be an increasingly important vehicle for investors to access depleted fixed income liquidity, reduce costs and improve trade efficiency. There are regional variations, but their popularity in Asia is set to grow.

Exchange Traded Funds (ETFs) are a well-established and still rapidly growing alternative to mutual funds. They combine the benefits of diversification in a passive portfolio with the liquidity and security of a stock exchange listing. Most attention focuses on the wide array of equities vehicles available, but increasingly, bond ETFs are gaining traction.

It’s not difficult to understand why. During the past few years, regulatory proscriptions and stricter capital adequacy ratios have imposed balance sheets constraints on banks that had provided liquidity to the fixed income market through their ability and willingness to hold inventory or take short positions. The Volker Rule and Basel III have curtailed banks’ capacity to hold large bond inventories.

At the same time, new government issuance volumes soared as central banks implemented quantitative easing policies, while companies across the credit spectrum raised long-term debt at historically low borrowing costs from investors hungry for incremental yield.

Hence, a vibrant primary market sometimes contrasts with a tepid secondary market. New investment grade bond issues are typically over three times oversubscribed. However, less than a third of large issues trade daily, and bid-ask spreads have widened more than 70% since 2007.

Nevertheless, the bifurcation has also provided market participants and industry service providers with an opportunity.

ETFs can provide liquidity and low costs
As one of the world’s largest bond investors, BlackRock is a beneficiary of this environment. Yet for several years, we have been enthusiastic about the merits of fixed income ETFs as a complement to active investment strategies. They comprise only around 0.6% of the underlying bonds markets, compared with equity ETFs which make up about 4% of the underlying, but they are set to grow in popularity.

In several ways, ETF trading is a potential precursor of the future operation of the bond market, exhibiting low cost, transparent, on-exchange trading in a standardised, diversified product. ETFs can enhance price discovery, provide investors with low execution costs to establish a diversified portfolio, and increase bond market liquidity and transparency.

ETFs combine characteristics of both stocks and traditional open-end mutual funds. Like a stock, an ETF can be bought and sold on the exchange intraday; like an open-end fund, ETF shares can be created or redeemed during the trading day – although, with the difference that these primary trades are facilitated by a group of institutional firms, known as approved participants (APs) who have entered into an agreement with the ETF’s distributor.

Primary trades do not require securities purchases or sales by the ETF. Instead APs present a basket of securities to the ETF provider in exchange for ETF shares. APs also act as agents for creations and redemptions on behalf of their clients, whether market makers or end-investors.

ETF liquidity can be additional to the underlying bond market liquidity because buyers and sellers can offset each other’s transactions without having to trade in the underlying market. Being able to trade fixed income ETFs on a stock exchange, away from the bond market itself, can provide a layer of additional liquidity that is not present in many other financial instruments.

The bid-ask spread for one of BlackRock’s High Yield ETFs (which was launched in early 2007 on the eve of the global financial crisis) averages one basis point (bp), compared with 50bp for a basket of US high yield corporate bonds, and 14bp for one of our Euro HY ETFs compared with 85bp for the equivalent basket.

Stress tests
Even during periods of market stress, ETF shares are at least as liquid as the underlying portfolio securities. For instance, according to BlackRock and Bloomberg research, more than $1 billion shares (12% of total cash bond trading) of the ETF mentioned above were traded in a single day in June 2013 in the wake of former Fed chairman Ben Bernanke’s taper speech the previous month, yet there was no underlying impact.

Furthermore, the shares of the High Yield ETF often traded at premium to the portfolio’s net asset value during the weeks of uncertainty following the Fed’s signal that it intended to reduce its asset purchases.

Again, in December 2015, when there was a pronounced risk-off market in high yield, the corresponding BlackRock ETF traded more than $32 billion for the entire month. At the same time, the amount of net redemption for the fund was around $334 million, so the ratio of volume that cleared on the exchange away from the underlying market was roughly 20-to-one. In normal times, the ratio is a still impressive nine-to-one.

In fact, most trading happens on the stock exchange, and the underlying isn’t actually traded in the bond market. Daily trading volumes of this particular ETF regularly amount to $1 billion, whether the bond markets are risk-on or risk-off. Since 2008, liquidity in the fund has grown 371 times versus a 52 times growth in assets.

Bond ETFs have endured multiple stressed markets including the 2008 financial crisis, European sovereign debt crisis, US Treasury downgrade, taper tantrum, oil sell-off of 2014 and high yield corporate bond sell-off and fund “gating” seen in late 2015. During times of stress, fewer corporate bonds tend to trade over-the counter, while bond ETFs often see increased trading volumes.

Institutions, such as pension funds and insurance companies, throughout the world are using fixed income ETFs to enhance portfolio liquidity amid a decline in overall underlying bond market liquidity. ETFs mean they can gain exposure to an index without the burden and uncertainties of making thousands of individual trades; they are also a convenient vehicle to park cash when a firm is in the process of transferring funds to a new manager. Moreover, optimisation techniques allow the ETF manager to track the benchmark by purchasing representative bonds, thereby minimising dealing costs.

Regional variations
The North American fixed income ETF market dominates in terms of size and continues to experience significant inflows, with a total of $456 billion in assets and the European market is growing at a fast pace with total assets at $146 billion.

Asia is the smallest market, with fixed income ETF assets of $9 billion, but the region’s investors are significant buyers of non-Asia ETFs, holding approximately $79 billion of iShares ETFs as of end February 2017, $15.9 billion of which is in fixed income iShares ETFs . Nevertheless, ETFs composed of Asian bonds, whether US-dollar denominated or local currencies, are likely to grow.

Currently, ETFs are being used for a wide variety of strategic and tactical applications in the region. The two most common uses, according to a Greenwich Associates paper, “ETFs Take Root in Asian Institutional Portfolios” (2016), are strategic in nature: obtaining core investment exposures and international diversification within portfolios. These strategic uses of ETFs by Asian institutions are being adopted at a much faster pace than they were at a similar stage in North America and Europe.

Asian institutions’ need for liquidity and quick access to support their sizable fixed-income portfolios could also speed up the adoption of bond ETFs in the region.

According to the Greenwich Associates paper, ETFs make up only about 1.4% of Asian fixed-income assets, and only about a third of Asian institutions employ bond ETFs. If Asian investors follow the example of US and European institutions, and broaden ETF allocations to include fixed income, it will have a profound impact on the size of ETF holdings in the region.

However, there are hurdles that inhibit a faster development of the sector. Despite fast growth in primary issuance in many Asian markets, secondary market trading and liquidity remain sub-optimal and fragmented. Asia ETFs should grow as the regions’ disparate domestic bond markets become more integrated.

Regulations also need to be further streamlined to facilitate not only innovative products but also access to ETFs. For instance, in most Asian countries, fixed income ETFs owned by insurers are viewed by regulators as equity rather than bond securities – unlike in the US and Europe. Also, the widespread use of retrocessions favours the distribution of mutual funds, rather than ETFs, to retail investors.

The region’s demographic changes and its funding requirements for infrastructure and urban development are likely to lead to more accessible, sophisticated and harmonised bond markets, which in turn should spur the growth of fixed income ETFs.

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