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).