Transferring a mandate from one money manager to another is almost always a delicate maneuver. The successor manager, with cash to invest, has to find ways for the portfolio to reflect market changes during the short time he needs to sort out his longer-term asset allocation. In equities there are several possibilities. He can trade stock options, futures or exchange-traded funds, which are passively managed index funds available at local equity bourses. In the corporate credit market, however, the portfolio manager may find himself out of luck. That’s because there is no futures market for corporate bonds.
A new type of security -- ETFs based on corporate bond indexes -- aims to fill this void. The new security offers money managers relatively inexpensive exposure to credit markets, which they can use for transition management as well as for short-term asset allocation or to short corporate bonds.
Equity ETFs have been around since 1993, but the first corporate bond ETF debuted in July 2002 in the U.S. The IShares GS $ InvesTop Corporate Bond Fund, launched by Barclays Global Investors, tracks the GS $ InvesTop index, a basket of 100 representative U.S. investment-grade credits. The fund raised $750 million.
“All ETFs bring a certain utility to the market,” says Mark Rogers, a principal at Barclays in London. “But this product is more significant because it allows market players to do things that have not been possible in the past.”
New strategies can be pursued -- but only up to a point. That’s because, as in all young markets, liquidity can be a real problem. Says Raymond Dalio, president and chief investment officer of $40 billion-in-assets bond specialist Bridgewater Associates in Westport, Connecticut: “These new ETFs are interesting in the abstract, but we haven’t spent too much time worrying about how we might use them, because the liquidity to trade them simply doesn’t exist. It would be a waste of our time.”
Nonetheless, in March Barclays introduced a second corporate bond ETF, dubbed IShares IBoxx E Liquid Corporates Exchange Traded Fund. It raised an impressive E760 million ($885 million), making it by far the largest ETF launch in Europe to date. The fund’s three sponsoring banks: Barclays Capital, Credit Suisse First Boston and Dresdner Kleinwort Wasserstein.
Says Barclays’ Rogers: “If you want to buy exposure to the FTSE 100 [equity] index you have a range of choices -- options, futures, mutual funds, ETFs. If you wanted to buy exposure to corporate credit as an asset class, you either bought bonds in the cash market or government bond futures as the next best proxy. The ETF offers instant and cheap exposure, and it fills a real market gap.”
Certainly, the cost is reasonable: The total expense ratio of the IBoxx ETF is 20 basis points, compared with 39 basis points for a U.S. indextracking mutual fund, according to Morningstar, and 117 basis points for the average U.K. bond fund, according to Fitzrovia International.
Although 284 equity ETFs are currently trading on global markets, only five bond funds trade. Three are government funds, and two are corporate. Morgan Stanley estimates that $145 billion is invested in ETFs worldwide, of which a pittance -- less than $4 billion -- is devoted to bonds.
Rogers says these totals partly reflect client demand. But they also mirror the relatively slow evolution of corporate bond indexes. Most of them -- the market leaders include the Lehman Brothers global aggregate bond index and the Salomon Brothers investment-grade bond index -- have a single pricing source and relatively opaque rules governing which bonds are included and why. Because equity index tracking is so much better established, the rules are more transparent, money managers report.
The IBoxx index series has seven contributing banks: ABN Amro, Barclays Capital, BNP Paribas, Deutsche Bank, Dresdner Kleinwort Wasserstein, Morgan Stanley and UBS Warburg. These banks guarantee that they will price each fund in the IBoxx indexes every 60 seconds. These prices are then fed into an independent price-fixing agent operated by Deutsche Börse. Sean Park, head of credit trading and debt syndicate at Dresdner, says this level of transparency was specifically designed to facilitate the development of index-tracking products such as ETFs.
“It was a classic chicken-and-egg situation,” says Rogers. “Without an index we could replicate, which was rules-based and transparent, we would not have launched our ETFs.”
Laurence Mutkin, head of bond strategy at Threadneedle Investments, a $70 billion-in-assets London-based asset manager, says that ETFs will be most useful when a mandate is handed off from one money manager to another. Pension funds and other institutional clients are more carefully monitoring these so-called transition events.
“The new ETF offers exposure to corporate credit, and that is certainly attractive during a transition,” says Mutkin.
ETFs are also an effective short-term asset allocation tool for money managers like Mark Watts at Baring Asset Management in London. For its $15 billion bond business, which is benchmarked against the Lehman Brothers global aggregate index, the firm stresses a tactical asset allocation approach, opportunistically switching in and out of credit.
“For corporate credit, the decision on the sector is more important than the security selection of a specific bond. It’s often a quick, tactical move,” says Watts. “In that scenario an ETF is ideal. The last thing we want is bond-specific risk. We want diversification, and that is what the ETF gives us.”
Large institutional managers are most comfortable using the ETFs as a short-term exposure tool, either in transitions or to express a tactical asset allocation view. But, like futures, ETFs can also be sold, creating a synthetic short position in credit. The three brokerage houses that led the IBoxx issue in Europe -- Barclays Capital, Credit Suisse First Boston and Dresdner Kleinwort Wasserstein -- are acting as market makers for long-only funds, and their repo desks will also offer the ability to go short.
For fund managers with little credit sophistication, the ETF could be a long-term core holding. However, Threadneedle’s Mutkin believes such indexing is incompatible with the current corporate credit environment. “There is so much rating transition and [so many] companies going bust that all an index guarantees is that you get a little bit of all of them,” he explains. “What’s the point of slipping on every banana skin that comes along?”
Lee Thomas, chief global strategist at Pimco Advisors in Newport Beach, California, offers a different perspective. “The general idea behind ETFs -- a diversified basket of credit -- is the right one,” he says. “As all fixed-income managers saw in 2002, when you have the wrong names in the portfolio, you get crushed. This is not a market for big bets. It is better to be fully diversified.”
Although the new ETFs may not provide as much liquidity as money managers would like, the underlying market for corporate bonds can also be relatively illiquid. On both sides of the Atlantic, managers are frustrated by the difficulty of trading certain names that appear in widely used indexes, such as the Lehman Brothers global aggregate bond index, which covers both government and corporate bonds.
Says Baring’s Watts: “There are a lot of bonds we would like to buy that aren’t being shown by the Street.” But the corporate bond ETF and other structured products, says Watts, have “bid-offer spreads that are much tighter than the underlying cash markets.”
Dresdner’s Park says that he and his fellow market makers are committed to the product for the long term. Ticket sizes of several hundred million euros can be accommodated, he notes.
Proponents of the new corporate bond ETFs hope that the product will offer greater liquidity than many individual bonds. As Pimco’s Thomas notes: “Liquidity in the bond markets has an illusory quality and contrary nature. It is there when you don’t need it, and as soon as you need it, it’s gone.”
The relative illiquidity of the new market for corporate bond ETFs may ease with time, advocates say. Because the ability to trade tactically in and out of credit quickly and go short is a new-found freedom, fund managers will have to reengineer their investment processes to take advantage of this new tool.
At the moment, says Baring’s Watts, most client mandates are so tightly prescribed that trading new products requires prior permission. He is currently going through the approval process with three U.S.-based pension fund clients.
He’s bound to be an optimist, but Barclays’ Rogers is convinced that the new product will grow dramatically. He says, “This is a significant innovation -- E760 million is just the start.”
