Fixed Income ETFs Bring Modernization to Bond Markets
At pivotal moments, investors embrace new methods and products to pursue their ongoing objectives. One such inflection point occurred this spring, when bond markets suffered the greatest volatility, dislocation and liquidity challenges since the Financial Crisis of 2008–2009.
After a steady march upward for over 17 years, fixed income ETF growth accelerated in March 2020. Bond ETF trading volume surged by orders of magnitude, vaulting to $1.3 trillion in the first quarter of 2020, which represented half of the $2.6 trillion in ETF shares traded in all of 20191.
What catalyzed this tidal wave? Investors turned to ETFs in their urgency to find liquidity, access, and efficiency. The number of high yield bonds quoted by dealers was down 80%,according to IHS Markit, and individual name bonds traded at wide bid-ask spreads – if they were trading at all.
As trading volume swelled, fixed income ETFs provided a key source of price discovery. Their on-exchange market prices reflected bond market prices, which gave investors a tool to analyze and understand the wild price volatility.
The Investment Decision
Prompted by upheavals in bond markets in March and April, investors dramatically increased their usage of fixed income ETFs. This class of instruments has matured, coming of age to emerge as a common element in the investment toolkit.
Investors are more fully appreciating the complexity of fixed income ETFs, as these vehicles provide a number of sophisticated use cases for implementing investment choices in swift-moving markets. Pension funds and insurance companies increasingly employ ETFs to reduce complexity and streamline portfolio construction, for example, while asset managers can turn to them for rapid, efficient allocation.
“Fixed income ETFs didn’t represent the final piece of the investment decision. In fact, they constituted the beginning of the exercise,” says Josh Penzner, Head of iShares Institutional Fixed Income at BlackRock.
In an environment where the number of bonds quoted and trading is suddenly shrinking, how do you price your assets? How do you assign and manage your risk? And ultimately, how do you make asset allocation decisions?
Penzner continues that “fixed income ETFs became central to understanding risk and valuation in the bond market, because what investors had traditionally relied on was less reliable.” Lacking the familiar indicators, they realized they could look to ETFs to identify opportunities and implement decisions.
At the heart of any investment decision, value must be addressed. What are specific securities worth, or, for that matter, what is the value of any asset? Consider a house sale, for example: There may be a large gap between an appraisal and an all-cash offer, especially during tough times. The same basic principle applies to securities, which might normally be marked-to-market; that activity becomes nearly impossible in a crisis market where individual securities are no longer trading.
Historically, institutional investors such as insurance companies and asset managers maintained “liquidity sleeves” of select, highly liquid securities in order to meet cash flow needs. However, in the recent crisis, they faced a sudden dilemma when liquidity dried up and those names became less liquid and harder to value. Fixed income ETFs proved to be another tool, offering them a guide to broad market valuation as well as single line-item liquidity.
This is possible because of the sheer number of trades on any given day. On March 12, one of the worst days for equity markets in modern history and a day during which credit markets sold off sharply, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) traded almost 90,000 times on exchange compared with just 37 times on average for its largest five bond holdings2.
A Practical Tool
Together with the dramatic increase in institutional adoption, ETFs are helping to modernize an evolving bond market. Penzner notes that, while changes advance slowly in fixed income, “bond ETFs are catalyzing that movement by shaping bond market investor culture and behavior.
“This year’s events have shone a bright light on the legacy structure and challenges of the bond market,” Penzner adds. The coronavirus selloff of earlier this year opened many investors’ eyes to the potential advantages of fixed income ETFs over individual bonds, from enhanced liquidity and transparency to transaction cost efficiency. Having witnessed those benefits, investors are now exploring further applications, with four core benefits of these funds driving adoption.
First, advances in electronic trading are enabling a more efficient market through more accurate, transparent pricing. Secondly, these instruments give access to markets that many investors could not normally reach on their own, which allows investors to build portfolios across fixed income sectors, utilizing factors such as credit quality, duration and maturity. Next, these vehicles provide liquidity, whether to manage portfolios, create liquidity sleeves, seek resilience or facilitate price discovery, among other functions. Lastly, ETFs create efficiency and streamline costs; instead of owning and trading 100 securities, investors can perform the task with just one transaction.
Such simplicity does not connote a lack of complexity. Having demonstrated their utility during a time of extreme turmoil, fixed income ETFs have proven to be a sophisticated option for institutional investors in various market conditions.
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This material represents an assessment of the market environment as of the date indicated; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.
There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.
Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.
When comparing stocks or bonds and iShares Funds, it should be remembered that management fees associated with fund investments, like iShares Funds, are not borne by investors in individual stocks or bonds.
Transactions in shares of ETFs may result in brokerage commissions and will generate tax consequences. All regulated investment companies are obliged to distribute portfolio gains to shareholders.
An investment in fixed income funds is not equivalent to and involves risks not associated with an investment in cash. Liquidity sleeves comprised of iShares ETFs are more volatile than allocations to cash vehicles.
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