Exchange-traded bond funds are on a roll. They gathered
$70 billion last year, a 31.4 percent increase over 2011,
according to New Yorkbased asset manager BlackRock. The
obvious explanation is that investors want low-cost,
transparent strategies for their savings. But theres
another reason for the soaring popularity of fixed-income ETFs.
Money managers, advisers, pension funds and insurance companies
are using these easily traded funds to prepare for the day when
interest rates begin climbing, bonds lose value and investors
scramble to sell into a market still largely dependent on
weakened Wall Street dealers.
In the wake of the financial crisis, the big banks have only
committed a fraction of the capital needed to maintain orderly
and liquid fixed-income markets. Thanks to regulations that
compel banks to hold a certain amount of reserves, and
proposals like the U.S. governments Volcker rule that
force banks out of proprietary trading, investors find it much
harder to buy and sell fixed-income securities. The
question is, how will the buy side manage the liquidity risk of
their fixed-income portfolios once interest rates start to rise
and net asset valuations get hit? says Will Rhode, New
Yorkbased director of fixed income at research firm TABB
Fixed-income ETFs started taking off in late 2008, when the
credit crunch froze parts of the bond market. Investors quickly
realized that these transparent funds were highly liquid and
gave frequent price signals all day long. ETF volume has
grown six times in four years, says Daniel Gamba, New
Yorkbased head of BlackRocks $220 billion
iShares Americas institutional business. In 2008
illiquidity really made them relevant. The iShares
Investment Grade Corporate Bond ETF, which launched in 2002,
traded an average of $18 million a day and had
$3.8 billion in assets before the fall of 2008. During the
crisis average daily volume rose to $171 million; now that
figure is $274 million and the funds assets are some
I can be more nimble with a portfolio constructed of
fixed-income ETFs than with a traditional bond portfolio,
says Peyton Studebaker, director of trading at
$1.2 billion-in-assets Caprin Asset Management, a
Richmond, Virginia, manager of municipal and taxable bonds.
If theres a credit event, I can shift strategy
easily. With that in mind, Caprin offers three portfolios
consisting solely of muni and taxable bond ETFs.
Global asset managers use fixed-income ETFs to establish a
liquid portion of a mutual fund or other account,
BlackRocks Gamba says. Besides reducing the performance
drag from cash, this strategy provides a ready pot of money for
investor redemptions. Bond ETFs also let portfolio managers
swiftly take positions in high-yield and other tough-to-access
corners of the market. As they find individual credits, they
can sell down their ETFs, Gamba says.
At the same time that dealers are committing less capital,
corporate issuance has increased in the face of loose monetary
policy and demand from yield-hungry investors. Flows into fixed
income have been at record levels since the financial crisis.
If no one is really looking to sell that often
theyre really looking to buy then as a dealer I
dont have to worry that much, says Robert Smith,
president of Sage Advisory Services, an $11 billion
investment firm based in Austin, Texas. And on the
margin, the electronic trading networks can handle the daily
churn because everyone is going one way. But, Smith
worries, what happens when higher rates push investors to flood
the market with bonds?
Sage, whose clients include insurance companies, endowments,
unions and high-net-worth individuals, uses ETFs as the
common mans way of hedging liquidity issues in the
market, Smith says. Big asset managers can deploy a
variety of derivatives to hedge against a complex series of
credit events. Our clients only real liquidity is a
traders bid, Smith concedes. I hope they can
find it in a fast-moving market.
Smith points to a split between big and small institutions.
Wall Street dealers still covet the large asset
managers, hedge funds and other institutional investors that
generate huge transaction volumes. In a crisis those clients
will get the liquidity while smaller players will probably end
up waiting in line.
Since 2007, Sage has used ETFs to offer fixed-income
core-plus-style portfolios; popular in the past decade, such
portfolios saw managers add a 10 to 30 percent allocation to
high yield, emerging markets, preferred stocks, commodities and
other alternatives on top of holdings such as Treasuries and
government agency bonds. When liquidity dried up in 2008,
core-plus quickly turned into core-minus, Smith recalls.
ETFs allow me to fight that core-minus aspect, he
says. I cant control my clients decision to
sell, but I can control how much they get hurt by how I got
them into the market in the first place.
New rules for Wall Street banks are supposed to help
prevent the next crisis, but asset managers and other investors
fear the unintended fallout. In the drive to correct the
excesses of Wall Street and to contain the greed,
regulators also destroyed the liquidity of the Street,