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March 30, 2014 7:51 am
Exchange traded funds linked to fixed income markets have made a flying start to 2014, with unexpectedly strong inflows that point to bond ETFs becoming more widely used by institutional investors.
A recent survey of 104 institutional investors by Greenwich Associates, the consultancy, found that one in five non-users planned to start investing in fixed income ETFs in the coming year, while two-thirds of existing users had increased their usage since 2011.
Growth this year has accelerated. US-listed bond ETFs attracted inflows of $14.1bn by the end of February, double the total registered over the whole of 2013.
Fixed income ETFs are relatively new investment vehicles and unfamiliar to a wide range of bond market participants, but interest has grown since the financial crisis. Around $223bn has flowed into fixed income ETFs globally over the past five years.
ETF providers believe this is just the early phase of adoption, arguing that ETFs will play a much larger role in bond markets as big investors learn to appreciate their flexibility when performing both tactical adjustments and strategic portfolio shifts.
But concerns about liquidity and the costs of fixed income ETFs remain as barriers that inhibit more widespread use by institutional investors, according to Greenwich.
At first glance, liquidity appears plentiful in the US bond market with daily trading exceeding $800bn. However, Victor Lin, an analyst at Credit Suisse, says this headline figure can be “deceiving”, as 95 per cent of activity is concentrated in Treasuries and mortgage-related bonds.
Relatively little is linked to corporate debt. Mr Lin says this presents an opportunity for greater adoption of bond ETFs. Trading costs for some of the most popular corporate bond ETFs are already lower than bid and ask spreads for the underlying bonds they track.
In the 2008 financial crisis, trading volumes for corporate bonds fell by as much as half, as brokers pulled back from the market. This encouraged investors to turn to bond ETFs as an alternative source of liquidity.
Matthew Tucker, head of iShares’ fixed income strategy team, says the 2008 crisis was a watershed moment for fixed income ETFs. He points out that daily trading volumes for LQD (the iShares iBoxx investment-grade corporate bond ETF) surged from $20m before the onset of the crisis to $190m in the final quarter of 2008.
Some active bond managers initially felt threatened by the emergence of passive ETFs, which trade on exchange and were not part of their traditional over the counter market, says Mr Tucker. They now realise how useful these instruments are for trading, he adds.
He highlights the depth of liquidity available in ETFs such as TLT (the iShares 20-year-plus Treasury bond ETF), which averages around $800m daily but can trade up to $5bn in a day with extremely low trading costs.
“It can make more economic sense even for seasoned Treasury traders to use the ETF for duration and risk trades than to trade the bonds in the underlying basket,” says Mr Tucker.
A challenge for all participants in fixed income markets after the financial crisis has been the huge decline in bond inventories held by dealers and banks’ trading desks because of changes in regulations.
This has occurred even as outstanding levels of corporate debt and assets held in bond mutual funds have risen substantially.
Institutional investors’ confidence in using fixed income ETFs can be demonstrated by growing numbers of “large tickets” (block trades). Buy and sell orders worth more than $5bn has been completed in two iShares short-term Treasury ETFs already this year.
Liquidity is also improving in the high-yield bond market where daily trading volumes for HYG (iShares iBoxx $ High Yield Corporate Bond ETF) have reached $400m a day.
“Trading the ETF is incredibly efficient for those than can operate within the limits of the liquidity offered on the exchange,” says Mr Tucker.
Arnaud Llinas, global head of Lyxor’s ETF and indexing business, describes the scale of inflows into fixed income ETFs this year as “a real surprise”, given the evidence of investors shifting from bonds into equities in 2013.
Mr Llinas attributes some of the growth to the increasing popularity of multi-asset investment strategies. Mr Lin agrees, saying that the strong influence of macroeconomic policies on global markets suggests that cross-asset trading will grow further.
“Vehicles like ETFs that provide an efficient, transparent way to access what can be challenging markets should increase even more in popularity,” he says.
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