The Accidental Modernization of the Fixed Income Markets
Even though legitimate criticisms of exchange-traded funds persist, data shows that investors used ETFs to help them get through the worst of the dysfunction in this year’s credit markets.
After dire predictions that exchange-traded funds would exacerbate volatility in fixed income, investors instead used ETFs to skirt many of the antiquated bond market’s structural problems.
ETFs, which hold a large basket of securities, trade on an exchange like any stock. Critics have been concerned that a market downturn would prompt mass ETF selling, which would require managers to dump individual securities and put even more pressure on creaky primary bond markets.
As economies buckled under the strain of Covid-19 earlier this year, investors found it almost impossible to buy or sell securities in the primary markets in almost every fixed income asset class, including investment-grade corporate and high-yield bonds, structured securities, and even, briefly, U.S. Treasuries, the most efficient market in the world. Because of the dysfunction and infrequent trading, asset managers and investors didn’t have fresh and accurate prices on their positions and some credit hedge funds even halted redemptions while they waited for the markets to stabilize.
Asset managers, pension funds, and insurance companies, in particular, turned to ETFs to increase their exposure to credit when they thought the securities were trading at historic discounts. They also used ETFs to avoid the high transaction costs in primary markets and efficiently and cheaply raise cash to meet rising redemption requests from investors, according to Carolyn Weinberg, global head of iShares product at BlackRock.
Of course, BlackRock has a vested interest in defending fixed income ETFs. Over the years, hedge fund manager Carl Icahn and others have publicly criticized CEO Larry Fink for creating and supporting what they have called “weapons of mass destruction.” BlackRock also buys corporate bond ETFs for one of the Federal Reserve’s programs that the central bank enacted to stabilize markets during the chaos in March.
Weinberg knew sparks would fly over ETFs. “We expected more critics, but we had endless cheerleaders,” she said. “The critics turned into users and saw the benefit.”
She estimated that 60 pension funds, insurers, and asset managers were first-time buyers of fixed income ETFs during the first quarter. Those 60 invested about $10 billion in iShares fixed income ETFs, she said. Global fixed income ETFs, including BlackRock’s iShares, grew about 30 percent in the last 12 months ending June 30th, reaching $1.3 trillion, according to the firm. About 84 percent of the total came from new money from investors.
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One of the biggest benefits of ETFs has been the availability of real-time prices. Hedge fund managers and mutual fund managers told Institutional Investor that they use the prices of fixed income sector ETFs, such as high-yield or structured credit, as a proxy for often unobtainable prices in the primary market. One mutual fund manager said he didn’t want to be quoted because retail investors don’t fully understand the lack of transparency in primary bond markets.
Weinberg explained that ETFs trade at “actionable” prices as opposed to the prices that were available in the underlying OTC market, which are often just an indication or an estimate of where a dealer may buy or sell a position at a certain size. For example, on March 12th, one of the worst days in the markets, BlackRock’s investment grade corporate bond ETF traded 90,000 times on the exchange compared to 37 times on average for the ETF’s five largest bond holdings.
“What’s the right barometer for price?” she said. “An actionable price based on 90,000 trades a day or a couple bonds that traded 30 times a day?”
Asset managers that didn’t have at least a small position in ETFs in their bond portfolio also suffered once they had to meet redemptions from nervous investors. These managers needed to sell individual bonds to raise cash as the opaque market was declining quickly.
Invesco also found that investors used ETFs in the crisis for liquidity and price discovery. Rob Waldner, chief strategist and head of macro research for the Invesco’s fixed income group, said that when the firm recently surveyed about 160 investment professionals, about 60 percent said that they used ETFs to help with liquidity. Waldner believes that ETFs passed their first big test this spring. That’s because ETFs continued to trade at real-time prices, like any security, during a period of uncertainty. Without those prices, the underlying market might have entirely seized up, he said.
According to Weinberg, fixed income ETFs have forced firms across Wall Street to make investments in technology and pricing analytics over the last five to 10 years. To deal with ETFs, dealers needed to figure out how to price a portfolio of bonds efficiently. That effort alone raised transparency.
“That has electronified the underlying market and added significant analytics that weren’t there before,” she said. “When you layer in the ETF on top of that, you shed a big light on the underlying market.”