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ETFs a Window Into the Bond 'Sausage Factory'

Paul Justice, CFA

Paul Justice: Perhaps no one in the ETF industry knows more about fixed-income products than Matt Tucker of iShares. I'm Paul Justice from Morningstar. I'm joined by Matt today to discuss the fixed-income landscape and the products that he has helped bring to market as managing director at iShares.

Matt, thank you for joining me.

Matt Tucker: Thanks, Paul, for having me.

Justice: You've got an incredible challenge and opportunity ahead of you in developing the fixed-income landscape, something that was probably unaddressed early in the ETF evolution.

You're really leading that effort. Would you mind talking about how you've come up with some of the product strategies and where you've seen great successes in the industry and what challenges that you've overcome from the early stages?

Tucker: Sure. I think when you bring it back to the growth in really the evolution of the fixed-income ETF market, it helps highlight some of the initial challenges that we faced.

If we think about the issues you faced just in fixed income, it's an over-the-counter market. You can't see price transparency. It's harder to execute. It's not an exchange market. So, actually taking that market and repackaging it on to the exchange through the ETF created a lot of challenges. How do you deal with a lack of price transparency? How do you deal with accrued interest, which is something that we take for granted in fixed income but was a fairly novel idea in equity markets to actually introduce that as part of valuation.

So, as we've gotten through those challenges, we've been able to bring to investors' products that at first were relatively plain vanilla, liquid corporate bonds and Treasuries, and now, we've evolved the structure to bring out things like high yield, emerging markets, and international global sovereign.

So, I think that as you've seen us improve the technology around the fixed-income ETF, it's allowed us to provide investors access to more and more asset classes.

One of the big innovations that I would love to highlight is just this idea of really breaking apart the creation of redemption basket, and I'm sure for a lot of your audience, they are fairly familiar with the ETF structure.

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Justice: Sure.

Tucker: If you think about the classic structure in, say, an S&P 500 fund, you have 500 stocks. When there is a creation in that fund, that fund takes in those same 500 stocks. If there is a redemption, it sends out the same 500 stocks. So, there's parity between what the fund holds and what it delivers or receives on a given day.

In fixed income where liquidity is discontinuous, that model wouldn't work. I may hold 100 bonds today, but who knows if I can actually go and ask for those tomorrow on a creation or be able to deliver those out and have them be sold in the market on a redemption.

So what we had to do is develop a new process, which we called "The Three Baskets," which is just this idea that we're going to take a creation basket and have it based on more liquid securities and a redemption basket really based upon what we think we can sell or investors can sell in the marketplace, and a portfolio which could be different. What it allows us to do is to offer investors very diversified, very deep funds that they have exposure to and still facilitate liquidity and creation-redemption.

Justice: So, you've taken a market that's typically--the bond market, trades were done over the telephone--you've introduced them to the exchange nature and brought a new level of liquidity that really didn't exist before these ETFs were trading. This is a great opportunity for someone to maintain if they have to sell bond exposure, they really can, or if they want to pick it up quickly, they can in the ETF market because you're trading this fund between two different parties. It's not necessarily all the time going up to that creation or redemption level.

Tucker: And I think that's actually a great point. If you look at the bid-offer spreads, look at, say, the muni bond market; you can buy and sell diversified muni bond exposure through an ETF for 8 basis points bid offer. If you want to trade individual bonds, you'll pay 125 basis points. So it's a tremendous increase in really the efficiency and the lowering of the transaction cost for investors.

But it's not magic, right? Costs have to be paid. But the beauty here is that the ETF creates a liquidity layer which resides above the bond market. So, you and I can exchange value in a muni bond ETF and no one has to trade a bond, and that creates that efficiency and really provides a real access vehicle for investors that makes it much more efficient to trade fixed income.

Justice: I think it's wonderful. You are actually providing a great benefit in a new avenue that people didn't have access to before.

But as we've evolved, there has also been a challenge, this perception challenge of fixed-income markets, the benchmarks, would show what one value would be, but that was a calculation of trades that never happened. And now the ETF actually realizes value. So some people say there is this big, oftentimes, there is this tracking error, and in our opinion, it's really a benchmark problem, not a product problem.

You've found price discovery with these exchange-traded funds, and it's really made our thinking evolve and what are we going to have to do to really say, is this fund doing what it's supposed to do, because conceptually they look like they are working wonderfully to me. Do you find that's a challenge when you're pushing that out to a client?

Tucker: I think it is a challenge oftentimes, and I think a lot of investors start with a foundation of equity ETFs and thinking about how equity ETFs respond relative to the equity market. And to really understand fixed-income ETFs, you have to start with the bond market itself. The fixed-income market, the bond market, is incredibly convoluted.

Trades are done over-the-counter between two parties. You and I can trade a bond at one price, I can turn and trade that same bond with somebody else five minutes later, and there is no connection between those prices and there is no information sharing among all three parties. You and the other party wouldn't know what you traded at.

So you have this incredibly fragmented market, and so differences in valuation, and also you can see big dislocations in price. And so, in a lot of ways I think about this – it's a sausage factory, right. Sausage factories are very ugly and it's messy. What the ETF has done is provide a window into that sausage factory, and people see that and say, wow, look at these bonds prices, they are moving around. My ETF is moving away from some theoretical end-of-day price; it must be broken.

It's not broken. I mean that's what's been happening every day with every bond for decades. You just couldn't see it before. So, in that sense, the ETF has I think really helped investors have visibility into and understanding of the fixed-income markets they really wouldn't have had before.

Justice: No, I think it's just another great example of how ETFs and iShares are really pushing the envelope and making the entire investment industry rethink some of the old standards that we held in play.

Thank you for sharing your insights on that.