Investors are slowly waking up to the benefits of bond ETFs.
In the 15 years since the launch of the first bond exchange-traded fund, assets under management of fixed-income ETFs in the United States. have grown from virtually zero to $537 billion as of March 16, 2016, according to Morningstar data. This rapid growth speaks to the wide range of applications investors have found for bond ETFs. This article explores a few notable use cases, and it will also show that performance is not always the most critical factor that investors consider when selecting fixed-income ETFs. Regardless of how investors use bond ETFs, growth in adoption should benefit all who use these funds. As the size of these funds’ assets and investor bases grow, liquidity improves and transaction costs decline. This growth also enables ETF providers to achieve economies of scale and in some cases to share the benefits of their greater heft with investors in the form of lower fees.
The explosive growth of fixed-income ETF assets is attributable to a number of structural changes in the capital markets. Specifically, investors are increasingly using fixed-income ETFs as a source of liquidity because post-crisis regulations have reduced liquidity in the U.S. bond market. Also, bond ETFs are replacing some derivatives traditionally used for fixed-income exposure. Finally, insurance companies are starting to embrace bond ETFs thanks to a recent regulatory change that allows them to hold credit ETFs without meeting onerous capital requirements.
A Source of Liquidity
Bond ETFs have become an attractive alternative to individual bonds as liquidity in the bond market has been steadily drying up. After the financial crisis, regulators imposed strict capital rules on banks, broker/dealers, and other liquidity providers who support secondary bond trading markets. They responded by pulling back their fixed-income market-making activities. For example, in 2007 primary dealers held bond inventories worth more than $200 billion. These inventories shrank to less than $50 billion as of June 2016 according to Federal Reserve Bank of New York data.
This development left the cash-bond market with fewer market makers and smaller bond inventories. To illustrate, more than half, or 56%, of investment-grade bonds tracked by the Markit iBoxx $ Liquid Investment Grade Index traded between zero and 15 days per month as of June 2016 according to the "Guide to Bond ETFs" report published by BlackRock. Meanwhile, the U.S. corporate-bond market mushroomed to more than $6 trillion. Consequently, there are more bonds and fewer brokers, resulting in higher transaction costs. Greenwich Associates' 2016 U.S. Bond ETF Study shows that more than two thirds of 70 surveyed investors, ranging from institutional investors to registered investment advisors, are incorporating liquidity costs more heavily to their investment decisions than they did before the financial crisis.
Fixed-income investors’ interest in ETFs has accelerated thanks to ample liquidity in the bond ETF market. Individual bonds trade over the counter rather than on an exchange like an ETF. And it is harder to find a willing counterparty to trade with in the OTC market, further contributing to individual bonds’ limited liquidity.
Bond ETFs trade $150 billion a month, or $7 billion a day as of June 2016 per Bloomberg. The trading volume of investment-grade ETFs and high-yield ETFs accounts for 4% and 17% of the trades in their respective underlying markets, respectively. The aforementioned BlackRock report also found that approximately four to six shares trade on the equity exchange for every one share in the investment-grade and high-yield bond market segments represented by the Markit iBoxx USD Liquid Investment Grade and Markit iBoxx USD Liquid High Yield indexes from June 2010 to July 2016. This large volume of trades lowers transaction costs. Also, the exchange-traded nature of ETFs makes these vehicles less reliant on secondary-market trading because they do not have to buy and sell in OTC markets to execute a trade. For example, the bid-ask spreads of iShares ETFs tracking investment-grade and high-yield corporate bonds were 16 and 42 basis points, respectively, as of June 2016 according to Morningstar. On the other hand, it would cost about 60 and 75 basis points, respectively, to acquire the underlying bonds of each ETF on the same day according to the estimate by BlackRock.
Some investors have adopted bond ETFs in place of derivatives typically used for fixed-income exposure. According to the 2016 survey by Greenwich Associates, 17% of 86 survey respondents, comprising institutional funds, investment managers, registered investment advisors, and insurance companies, replaced their derivative positions with bond ETFs during 2015. The respondents cited costs, operational complexity, and minimizing tracking differences as reasons.
Among these derivatives, an index total return swap was among the biggest candidates for replacement. An index total return swap is a contract in which one party makes payments based on the performance of the referenced index in exchange for receiving regular cash flows typically tied to Libor (the London interbank offered rate, used for short-term lending among banks).
There are several reasons that bond ETFs can be a good alternative for such contracts. For example, the bid-ask spreads of iBoxx credit index total return swaps were around 40-50 basis points from 2013 to 2014 according to BlackRock’s "Comparing Corporate Bond ETFs with Credit Derivatives" report published in May 2016. Credit ETFs tracking iBoxx indexes have traded in a narrower spread during the same period. In addition, because the index total return swap is a bilateral contract, it exposes investors to counterparty risk. There is always a risk that the other party may fail to make payments. Lastly, entering a swap agreement requires more onerous documentation requirements than purchasing a credit ETF. The major requirements include International Swaps and Derivatives Association master agreements and Credit Support Annex trade confirmations.
Insurance Industry Adoption
The insurance industry has started to embrace credit ETFs, largely driven by a recent regulatory change. In 2012 the National Association of Insurance Commissioners changed its rule that previously prevented insurance companies from holding bond ETFs as part of their liability reserve management. Since 2012, the NAIC has been assigning ratings to fixed-income ETFs, making some of them qualifying assets to support future liability claims. The claims are typically tied to loss or deterioration of life, health, property and casualty. According to WallachBeth, an ETF market maker, as of Oct. 3, 2016, 132 fixed-income ETFs have been rated by the agency and more bond ETFs are expected to be rated.
This change sparked the industry’s interest in fixed-income ETFs. As of 2015, insurance companies held about $15 billion worth of ETFs, per S&P. This sum is a tiny fraction of $7 trillion managed by the insurance industry, per Cerulli and A.M. Best, but it represents 146% growth, or 14% annual growth since 2006. This trend suggests there is even more room to grow. In fact, 52% of insurers who participated in the 2016 Greenwich Associates U.S. Bond ETF Study said they plan to increase their use of ETFs in 2017. In the same survey, the 80% of existing insurance ETF investors had increased their use of ETFs during the past three years.
There are other credit ETF features, such as a constant duration, that are appealing to insurance asset managers. In some instances, it is important for an insurer to maintain a constant duration profile because its liability duration is static. A bond is a self-liquidating vehicle. Hence, as the time lapses its duration shortens. An insurer must constantly replace the old bond with the new bond with a longer duration in order to match the duration of its asset to liability. Some bond ETFs maintain a duration profile within a narrow range. This characteristic allows a liability-driven investor to effectively execute its asset-liability management strategy.
Also, bond ETFs are a low-cost tool to diversify an insurance asset manager’s portfolio. Smaller insurers in the U.S. tend to focus on the U.S. investment-grade corporate fixed-income market. They typically do not have the expertise or resources to explore other markets. Credit ETFs with a high NAIC rating, such as 1 or 2, are low-cost tools to gain exposure outside of the firm’s expertise. For example, the 1 rated Vanguard Tax-Exempt Bond ETF VTEB (0.12% expense ratio ) is a persuasive option for an insurer looking for municipal bond exposure. For international exposure, VanEck Vectors Emerging Markets Investment Grade + BBR USD Sovereign Bond ETF IGEM (0.45% expense ratio) is rated 2 by the commissioners.
The rapid expansion of bond ETF assets and investors are beneficial to all investors in these funds. The more assets and market participants there are, the lower transaction costs will be. Additionally, as assets grow, ETF providers can further lower their management fees by leveraging economies of scale. For example, Vanguard Total Bond Market ETF BND dropped its fee to 0.06% from 0.11% between December 2010 and February 2017, as its assets grew to $32 billion from $9 billion. Similarly, iShares Core U.S. Aggregate Bond AGG grew to $42 billion from $11 billion during the same period. And its management fee dropped to 0.05% from 0.20% over that horizon.
This growth also highlights diverse applications for bond ETFs. In some pockets of the credit markets, ETFs provide better liquidity than individual bonds, offering an attractive substitute. Fixed-income ETFs can also be a good alternative to index total return swaps. With bond ETFs, investors can eliminate the counterparty risk associated with swap contracts and potentially transact at a lower cost. Finally, insurance investors are becoming a larger part of the bond ETF market, further improving the market liquidity and reducing ETF trading costs.
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