Fixed income ETFs: One to watch

Fixed income ETFs have witnessed unprecedented growth in recent years, spearheading the rise of the overall ETF market. Hayley McDowell asks why the product is so attractive to investors and what the future holds for the asset class.

The growth of the exchange- traded fund (ETF) industry has been an episodic experience, with new batches of products coming into the marketplace every three-to-four years. In the wake of the financial crisis of 2008, fixed income ETFs began to emerge from the shadows but in recent years the product’s growth has accelerated significantly.

According to data from Bloomberg Terminal, the fixed income ETF sector has been at the vanguard of the overall market’s progress during the past year, with a 17.5% annual growth rate. In comparison, the US Equity ETF growth rate stood at 7.9%.

ETFs are attractive investment vehicles to many investors due to the diversity the product can offer, but it has taken some time for institutional investors to come around to the idea of them. Certain regulators, market commentators and industry participants have spent a considerable amount of time trying to understand how ETFs function, with financial institutions putting in similar efforts to educate the market on how the products work.

This process has led to rumours of a potential bubble emerging, but as some of the world’s largest financial institutions embrace ETFs, the market has certainly shifted in their favour.

“While the fear of a potential ETF meltdown is still a topic for discussion, more and more professionals are beginning to understand the ETF infrastructure and the interaction of the secondary market, the primary market and the creation/redemption process, and how the market should be able to sustain pressures,” says David Mullen, senior business manager for fixed income ETF products and ETF trading platform at Bloomberg.

Fixed income ETFs may still be in their infancy but remain a rapidly growing segment of the industry. Global bond markets have undergone substantial change through the rise of electronic trading, consistently fragmented liquidity and a surge in passive investing. In this new landscape, senior market participants agree this has worked out positively for fixed income ETFs, as they play a significant role in next generation bond markets.

“The bond market has seen a lot of evolution in terms of changes in liquidity and a shift towards electronic trading,” says Brett Pybus, head of iShares EMEA fixed income strategy at BlackRock. “We have seen an increased use of technology in fixed income, and the introduction of equity-like trading plays to the strengths of bond ETFs. This is because they provide a very efficient way for buyers and sellers to trade without having to go through traditional dealers. They also provide transparency in a typically opaque bond market to clients by offering a window into where different bond exposures are trading.”

The world’s largest asset manager is at the forefront of the ETF boom, with its iShares business raking in $54.8 billion in Q4 last year alone. BlackRock has made significant outlays in technology expenditures in recent years as it looks to ensure order and deal flow facilitates growth in volumes, as well as leaning on the array of capabilities provided by its Aladdin platform.

According to Pybus, some of the firm’s most sophisticated technology is on the fixed income desk trading ETFs and managing those portfolios, with dedicated spending aimed at ensuring BlackRock’s clients are able to benefit from the product’s characteristics as efficiently as possible.

Index trading

Investment advisors are now joining the ETF party and gaining more understanding of the process as an alternative means of finding liquidity for individual bond holdings.

Mullen says that via this new and creative way of looking at creation/redemption portfolio managers can exchange a basket of bonds for new shares of an ETF and then hold the more liquid shares while maintaining rate and credit exposure, or sell the shares in the secondary market and go directly to cash. He adds that some managers have also begun to fund portfolios with individual bonds exchanged out of an ETF via the redemption of shares. This process again reflects the benefits of ETF investing as it is often faster and more cost efficient than investing in individual bonds.

The adoption of index trading in the biggest drivers in the growth of bond ETFs, which are increasingly used by a range investors for a variety of different purposes in portfolios. In some instances, they are adopted as building block exposures at the core of portfolios or as more tactical trading vehicles for the implementation of asset allocation decisions.

“We’ve seen increased ETF usage across all client channels, including platforms and independent financial advisors,” says Bryon Lake, head of the international ETF business at JP Morgan Asset Management. “In many instances firms are building out and developing their platforms to support ETF trading in response to burgeoning investor demand.

“While investors may be buying a single ticker on-exchange, in reality they’re getting diversification from a basket of bonds. Price discovery is another plus, as investors get exposure to bonds but with the trading transparency of an individual stock. A number of asset managers running fixed income portfolios may also use fixed income ETFs as a liquidity buffer. You’ll see more work from us on this front, in terms of product development, as we respond to growing investor demand.”

Growing investor confidence

Greater cost and trading transparency resulting from have acted as a catalyst for the increased adoption of ETFs. Transparency on cost firmly places the spotlight on value for money, while transaction reporting under the new regime should offer more insight into the pricing and volumes of ETFs. This is kick-starting a renewed interest in ETFs as investors evaluate different methods of trading which are perhaps more cost effective, according to BlackRock’s Pybus.

“We are seeing growing investor confidence in bond ETFs as they become a more central part of the fixed income ecosystem,” he says. “We have seen more of the traditional broker-dealers start trading bond ETFs, the same entities who historically focused on trading single bonds. At an industry level, there is a concerted effort on the part of clients exchanges, issuers regulators to learn more about how the bond ETFs work and the role they play in the markets.”

Another key driver in the adoption of fixed income ETFs came about early this year with the arrival of insurance companies. The National Association of Insurance Commissioners began publishing a list of approved bond ETFs for insurance company investors and introduced new accounting guidelines known as “Systematic Valuation” which provide a more ‘bondlike’ treatment of fixed income ETFs for accounting purposes. These changes are expected to attract more than $300 billion into debt ETFs, according to statistics from BlackRock.

The arrival of insurance money marks a significant moment for the fixed income ETF industry explains, Sage Advisory’s co-founder, president and chief investment officer, Bob Smith: “The potential for insurance money to come into the ETF market without the risk of suffering a decline in terms of risk-based capital of their holdings will be a significant force in driving the market towards stability.”

Sage Advisory is an Austin, Texas-based asset management firm with $12.8 billion of assets under management. The firm launched its own environmental, social and governance (ESG) credit ETF in October and has been actively engaged with fixed income ETFs for some time already.

“We have certainly embraced fixed income ETFs for insurance portfolios, corporate, and liability-driven investment (LDI) pension fund accounts across the board in a fairly creative fashion. It’s an attractive technology to apply but you need to get under the hood to understand how it works and trades in terms of liquidity,” Smith adds.

The future of the fixed income ETF industry, and the ETF industry as a whole for that matter, looks bright. With a variety of investors now seemingly embracing the product, armed with a greater understanding of how they function, assets under management and daily trading volumes seem set on a growth course.

The increase of liquidity in the ETF market presents an intriguing opportunity for asset managers in their pursuit of alpha. More products will likely come to market and as participant’s knowledge increases, so too will confidence levels. As investors continue to become educated on ETFs and regulation brings about new data on the performance of funds, the bond ETF industry is certainly one to keep an eye on in the near future.