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Focus on Fixed Income: Do fixed income ETFs distort the market?

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In this article, which is an excerpt from a recent State Street Global Advisors publication, we address one of the key misconceptions about fixed income (bond) ETFs – namely, that they have become so large that they are distorting the underlying bond market. Instead, we argue, despite their recent growth, fixed income ETFs represent a relatively small proportion of the world’s debt markets. 

And although ETFs generally account for less than 5% of assets in almost all segments of the broad USD fixed income universe, in many cases ETFs represent a higher proportion of the traded volume in the relevant bonds. Fixed income ETFs therefore provide a source of additive liquidity to those markets.

Fiction: The fixed income ETF market has become so large that it distorts the bond market

Fact 1: ETFs still have a small asset footprint

The fixed income ETF market is still relatively young: the first fixed income ETF was launched only in 2002. Even 10 years ago, assets under management in fixed income ETFs represented $48bn, only around 1.9% of the global fixed income fund industry, according to Morningstar. 

Meanwhile, ETFs accounted for a mere 0.2% of the investable global fixed income universe, as measured by the Bloomberg Barclays Multiverse index, which includes investment grade and high yield bonds issued in developed and emerging market currencies.

By 30 June 2018, fixed income ETFs had seen a remarkable growth in assets. On this date they represented 10.2% of the global fund market, with $800bn in assets. 

While the growth of these instruments has been robust, they still only account for 1.5% of the total investable fixed income universe. And flows into fixed income ETFs have not occurred solely at the expense of other types of investment vehicle. Instead, they have helped the overall market to grow.

Figure 1 shows the recent market footprint of ETFs within sectors of the fixed income universe, including US high yield corporate bonds, US investment grade corporate bonds, US investment grade floating rate notes, US senior loans, US municipal bonds, emerging market bonds, US government bonds and US mortgage-backed securities (MBS). 

ETFs’ ownership share across these sectors remains relatively small, varying from 0.4% to 3.2%.

etf aum vs total market aum

three month average daily volumes

Fact 2: In some fixed income sectors, ETFs are becoming a critical source of additive liquidity

But when measured by their contribution to trading, ETFs have a more significant role. Figure 2 illustrates how much ETFs account for in terms of trading activity, again measured by fixed income sector. Figure 2 also shows that in some fixed income sectors, ETFs are becoming a critical source of additive liquidity.

Whereas ETFs generally account for less than 5% of assets in almost all segments of the broad USD fixed income universe, in many cases ETFs generate a significantly higher proportion of the trading volume in the underlying bonds.

How do fixed income ETFs become an extra source of liquidity? The stock exchange upon which an ETF is traded becomes the venue where a variety of investor types congregate to position their portfolios and to express a fixed income beta exposure in either direction, long or short.

The resulting two-way flow in the shares of the ETF typically results in muted impact on the underlying market (for example, an ETF consisting of senior loans or high yield bonds may see only $1 of net share creation or redemption for every $6-8 of secondary trading value).

In high yield bonds, ETF trading may have begun to supplant volumes in synthetic products such as total return swaps and credit derivative swap indices (CDX). 

By comparison with the unfunded, margin-based nature of exposure to these synthetic products, ETFs offer a fully funded exposure. This generates a performance profile that better matches the cash bond market and avoids the multiple basis risks that exist with a synthetic exposure.

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