Fixed Income ETFs - A Game Changer for Bond Markets
Exchange Traded Funds (ETFs) are no longer predominantly associated with Equities and Commodities as fixed income ETFs have become known for their rapid expansion over the past few years with market share of European fixed income ETFs having steadily grown from 14% in 2010 to 22% in 2020. [1] Monthly flows data from ETFGI shows that globally listed fixed income ETFs/ETPs brought net inflows for 2020 to $160.61bn which is higher than the $147.99bn in net inflows fixed income products had attracted YTD in 2019. [2] Firstly, this article will explore reasons for this sharp increase in fixed income ETF flows such as the global interest rate environment, the Federal Reserve’s involvement in this market and other structural changes in ETF products. We will also focus on how fixed income ETF activity changed as a result of the global pandemic and the future broader implications for the underlying bond market.
What Are Fixed Income ETFS and What Has Driven Their Rise in Popularity?
Let’s start with ETFs – an exchange traded fund is a type of security that bundles a collection of securities and often, tracks an underlying index. They are similar to mutual funds, however, ETFs are listed on stock exchanges and traded throughout the day like an ordinary stock. Fixed Income ETFs are a type of ETF that exclusively invest in bonds or Treasuries. [3] Bond ETFs are unique because although they trade throughout the day on a centralised exchange, their underlying bonds are sold OTC (over the counter) by bond brokers. Unlike owning bonds, where the investor receives fixed dividends on a regular schedule, bond ETFs hold assets with different maturity dates, so the value of the coupon can vary by month. However, when interest rates rise, this can harm the price of the ETF, just like an individual bond.
Historically low levels of global interest rates have been a great environment for bond investors and illustrated well by the four-decade boom in returns on US T-notes (US 10-year Treasury notes). Low interest rates mean that the return on saving money is low and so bonds can provide an alternative safe investment strategy with a higher return. Fixed income ETFs provide exposure to the same benefits and have subsequently risen in popularity. However, with the potential for rising inflation in the future, this may erode the purchasing power of bond’s future cash flows and some believe that this will undermine bond returns and investment strategies will shift towards equities and alternative assets.
In this case, the popularity of fixed income ETFs may diverge from that of its underlying assets as the recent change in ETF products due to the SEC (Securities and Exchange Commission) approving “models” for ETFs where holdings are not required to be published daily, means that active managers can shield their portfolios. As recently stated by BlackRock chief executive Larry Fink at the Morningstar Investment Conference, “We’re seeing more and more active investors using ETFs for active management. They go in and out of passive exposures through ETFs, and the biggest transformation of that is in fixed income”. [4] As shown by the graph below, global bond ETFs have reached a record pace and 13.4% of net inflows into fixed income ETFs have originated from the actively managed bond sector.
Why Was the Growth in Us and European Fixed Income ETF Popularity Not Mirrored in the Asian Markets?
As shown by the info graphic below, fixed income ETF growth has been rapidly rising in US and Europe but there has been little advancement in the Asia Pacific; this includes Hong Kong, Singapore and Seoul. The trend in Asian countries is for private investors to favour short term profitable opportunities and a general tendency to invest in properties. However, the largest obstacle for bond ETFs are commissions in the private banking sector. In Hong Kong and Singapore, private bankers will expect to be paid a commission for putting their client’s money into a fund and low-fee bond ETFs are deprioritised due to low commissions.
“It’s quite a bit of employment, it’s quite a bit of tax revenue in these two small markets. I do not see any movement [towards banning commissions].” – Aleksey Mironenko, global Head of investment solutions at The Capital Company [5]
How Did Fixed Income ETFS Help Monetary Policy?
Among other efforts to stabilise markets during the first half of this year, the Federal Reserve started buying ETFs which were tracking the corporate bond market, for the first time in the history of the US Central Bank. Between 12th May and 17th June, the FED spent $6.8bn assets on corporate bond ETF purchases before Jerome Powell stated they would switch away from ETFs and back into buying bonds. [6] During the covid-19 sell off, the FED used bond ETFs to provide liquidity in fixed income markets and Steve Blitz, chief U.S. economist for TS Lombard said, “All of this is to make sure that people who want to sell have a buyer, The Fed is taking both sides of the market so people who need to raise cash can do so.” The choice to provide support in the ETF space as well as the underlying bond market is explained by Todd Rosenbluth, head of ETF and mutual fund research at CFR, “ETFs offer the benefits of impacting thousands of bonds in one trade”. [7]
How Can Fixed Income ETFS Solve Problems in the Bond Market?
Salim Ramji, Global Head of iShares and Index Investments at Blackrock and author of the global survey report of fixed income ETFs wrote, “Through the stresses, the largest and most heavily traded fixed income ETFs performed as our institutional clients hoped they would, by providing more liquidity, greater transparency and lower transaction costs than the underlying bond market”. [8] As the Covid-19 pandemic spread and there was a large sell off in markets, fixed income ETFs supported issues of liquidity and price discovery in the underlying bond market.
Over the counter trading venues, used for fixed income securities, cause issues with identifying total liquidity in the market as there are so many options to navigate; this is due to the high level of information asymmetry and lack of transparency in a decentralised system. In addition, the wide range of yields and maturities for very similar products makes it a time-consuming process to match buyers and sellers in the secondary bond market, which is facilitated by broker-dealers. [9] These tend to be large institutions who will offer a spread to maintain a profit margin which is usually driven by lack of price transparency for both parties and causes greater illiquidity. Fixed income ETFs not only solve the primary market issue as they are traded via an exchange, but they also have less liquidity issues in the secondary market. Liquidity of an ETF isn’t only derived from the liquidity of the underlying market because while the ETF creation and redemption process facilitated by AP (authorised participants) is a way to manage liquidity, the ETF can also be traded when buyers and sellers are matched directly through APs or market makers. A white paper from Invesco stated that the US listed bond ETFs traded a total of $738.8bn on exchange in March, with just $19.8bn redeemed in the primary bond market over the period. [9] During that period of great market stress and volatility, the fixed income ETF market demonstrated extremely strong liquidity.
The lack of liquidity and standardised system often means that bond prices are often negotiated with several dealers and hence, investors are provided different quotes based largely on the network of the dealer rather than the overall market supply and demand mechanism. This makes it extremely hard to assess the fair value of fixed income securities as there is no closing auction period. The NAV (net asset value) for the underlying holdings that fixed income ETFs are held to is based on theoretical bond prices; these are often very different from the trading price in volatile market conditions. In the Bank of England’s May Interim Financial Stability Report, it is stated that bond ETF prices “appear to have provided information about future changes in underlying asset markets, offering evidence that they incorporated new information more rapidly than the NAV of assets held within their, and equivalent, funds”. [10] Although, corporate bond ETF’s were trading at more than 5% discounts to NAV in March compared to maximum discounts of 0.1% in January, there seemed to be no arbitrage opportunity because ETF prices seemed to be reflecting tradeable bond prices better than the underlying assets themselves.
In this way, fixed income ETF activity over the past few months may catalyse changes to the underlying bond market such as an increase in central reporting of OTC trades and prices and more transparency of this data to improve price discovery.