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.
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.