This content is from: Innovation
Adapting to Rapid Change and Finding Opportunities in Fixed Income
Broker-dealers and market makers in today’s bond market are required to rapidly price and trade entire portfolios of bonds in order to facilitate fixed income ETF primary activity or client-driven portfolio trading. This activity has helped drive the dramatic rise of algorithmic bond pricing and further accelerated the adoption of electronic trading and alternative bond trading architecture such as all-to-all networks. As a result, fixed income markets are more transparent and offer lower transaction costs than ever. The breadth and widespread adoption of ETFs and other fixed income index exposures have been the impetus for all this change.
Investors who have embraced ETFs and fixed income index exposures have reaped the benefits of improved transparency, efficiency, and liquidity, leading to rapid structural changes in the global bond markets for investors. Such exposures are being used by investors as powerful tools for organizing and navigating the opaque, fragmented over-the-counter (OTC) bond markets rather than as a particular investment style.
This state of cohesion allows investors to engage with new strategies and tactics. For example, dealer counterparties can use fixed income ETFs to either hedge the inventory that is being aggregated in a portfolio trade or use the creation/redemption mechanism to source or liquidate resulting bond inventory from such transactions. The exchange liquidity of fixed income ETFs provides dealer counterparties with an efficient inventory and risk management tool.
Rapid, efficient portfolio construction
Improvements in operating platforms and technology have exposed previously hidden opportunities in portfolio management. No longer are portfolios being built and managed exclusively at the individual security level, but increasingly at the exposure level across betas, factors and alpha. Today, strategies are implemented using combinations of individual bonds, fixed income ETFs, and index derivatives.
Fixed income ETF options and other associated derivatives markets have converged to form a powerful ecosystem that is now firmly entrenched and is an integral part of bond markets – particularly credit markets. This ecosystem provides fixed income investors with a powerful toolkit for portfolio construction and risk management.
Going forward, it’s likely that fixed income portfolio managers will increasingly recognize that index exposures such as fixed income ETFs can serve as the beta and factor components of bond portfolios. Nearly all diversified bond portfolios and strategies contain elements of beta and factor exposure, whether intended or not. The cost of these exposures at the individual bond level can be quite high.
Rather than building these exposures with individual bonds, a portfolio manager could potentially benefit from liquidity, cost, and operational efficiencies by employing the use of low-cost index products such as fixed income ETFs.
For example, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) might help a portfolio seek higher income through exposure to an index composed of U.S. high yield corporate bonds (not to mention diversification/risk management with a single trade).
ETFs can also sometimes be more liquid than the underlying securities. In 2018, for example, near-record inflows of $98 billion for U.S. bond ETFs were accompanied by record-setting secondary trading volumes that reached an average daily trading volume of $8.5 billion – a significant increase of 41% from 2017.1
One of the most actively traded fixed income ETFs by investors seeking liquidity is the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), which has an average daily trading volume greater than 80% of Dow Jones Industrial Average stocks.2 LQD provides access to more than 1,000 high quality corporate bonds in a single fund, providing wide-ranging exposure for investors pursuing income.
As fixed income investors and portfolio managers alike come to better understand the sources of excess returns with respect to index, factors, and alpha, the use of index tools to implement beta and factor exposures may become more commonplace. Such a practice would free up the portfolio manager to allocate more time to high conviction, alpha seeking positions that cannot be replicated with an index exposure.
1BlackRock, Bloomberg, as of 06/30/2019
2BlackRock, Bloomberg, as of 12/31/18. Volume based on full-year average.
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Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.
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