For years, asset managers and asset owners used fixed income ETFs more at the margin – for tactical allocations or temporary exposure to a hard-to-access asset class. Some were put off by fixed income ETFs’ relative adolescence. And, while fixed income ETFs performed under various stresses over the past decade, others theorized about what might happen in the event of a true shock.
Then came the long-awaited test for fixed income ETFs: The COVID-19 health crisis materialized in the first half of 2020, rattling economies and bond markets around the world. Liquidity, price discovery, usage and transaction costs were severely challenged across multiple asset classes in the bond markets, from high yield and investment grade corporates to emerging markets and even – for a brief period – U.S. Treasuries. Through the stresses fixed income ETFs endured. The largest and most heavily traded fixed income ETFs provided more liquidity, greater transparency and lower transaction costs than the underlying bond market.
It has been 18 years since iShares debuted the first fixed income ETFs – and they are now a grown-up tool for even the most sophisticated investment strategies.
The onset of the COVID-19 pandemic triggered unusual disruption across fixed income markets and led to an uptick in activity for fixed income ETFs. During multiple periods of market stress over the past decade, the transparency, access, liquidity, and efficiency of on-exchange trading had already proven valuable to fixed income investors. Despite a solid track record, certain market participants theorized about what might happen should fixed income ETFs be tested by an unprecedented market shock such as that triggered by the pandemic. Questions persisted about whether ETFs would be able to withstand the pressure of continuous selling, and whether they might exacerbate price declines in the underlying markets.
When the shock came, the results were clear: Fixed income ETFs not only held up under stress, but they became important tools for market participants. Institutions turned to the most liquid fixed income ETFs as sources of real-time price discovery and cost-efficient execution when transparent quotations and liquidity had sharply deteriorated in individual bonds.
Volatility followed by surge in fixed income ETF trading
Investors have tended to increase their use of fixed income ETFs during times of uncertainty because they have shown to be efficient and effective tools for rebalancing holdings, hedging portfolios, and managing risk. In fact, during the immediate COVID-19 financial crisis trading in U.S. fixed income ETFs surged to $1.3 trillion in the first quarter of 2020 – half of the $2.6 trillion for all of 2019.
During volatility jumps, investors want to weigh all their options and have maximum flexibility. Practically speaking, that means they need liquidity, and U.S. corporate fixed income ETFs demonstrated they could provide incremental liquidity to the market as trading rose at a faster rate than trading in individual bonds as credit risk spiked.
Trading volume in all U.S.-listed high yield fixed income ETFs averaged as much as $7.8 billion per day in March 2020 and represented as much as 29% of individual high yield bond trading in the over-the-counter (OTC) market; for comparison, high yield fixed income ETFs averaged around 11% of OTC high yield trading in 2019. The trend was similar in U.S. investment grade corporate bond trading, where fixed income ETFs in March represented as much as 24% of individual investment grade bond trading in the OTC market, compared with 10% in 2019.
In both high yield and investment grade, as markets became more volatile, investors turned to fixed income ETFs.
Fixed income ETFs indicators of real-time, actionable prices
Many fixed income ETFs traded billions of dollars and tens of thousands of times per day on exchange during the peak of 2020’s early-year market volatility. This frequency of trading is orders of magnitude more often than the most heavily traded corporate bonds.
On March 12, one of the worst days for equity markets in modern history and a day during which credit markets sold off sharply, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) traded almost 90,000 times on exchange compared with just 37 times on average forits largest five bond holdings.
From February through April, the iShares iBoxx $ High Yield Corporate Bond ETF’s (HYG) and LQD’s average daily dollar trading volume was 25 times and 7.5 times more per day, respectively, than their five largest bond holdings.
High trading volumes support the notion that fixed income ETFs provided actionable prices for investors at a time when the underlying bond market was challenged. The on-exchange market prices for fixed income ETFs reflected both absolute and relative values and helped enable investors to understand rapidly changing market conditions.
Because they offer real-time pricing and trade often, fixed income ETFs are central to valuation, portfolio construction and risk management for institutional investors. In particular, fixed income ETFs have emerged as benchmark references for returns, volatility and market sentiment.
More efficient to trade, too
Market volatility creates pricing uncertainty and often translates into wider bid/ask spreads for all securities. Investors who turned to fixed income ETFs during the volatile early months of 2020 found not only real-time, actionable pricing but also lower transaction costs than were available in individual bonds.
While bid/ask spreads for fixed income ETFs did increase somewhat during this period of market volatility, they remained lower for iShares flagship fixed income ETFs than for individual bonds and bond portfolios across sectors; from the emerging markets to U.S. Treasuries, bid/ask spreads of the most liquid iShares fixed income ETFs remained lower than corresponding underlying bond portfolios (Figure 4).
While fixed income ETF trading costs are generally cheaper than those of the underlying bonds, this difference was magnified during 2020’s market turbulence – yet another signal they are up to the toughest challenges.
During the worst of the market turmoil in February and March 2020, fixed income ETFs became central to the investment decision-making process for a growing number of institutional investors. Given the lack of liquidity and price discovery in the underlying markets, portfolio managers and traders used fixed income ETFs to understand rapidly changing market conditions; help price individual bonds and portfolios; determine absolute and relative value opportunities that underpin allocation decisions; implement decisions rapidly and efficiently; and hedge unwanted risk. Here are two examples that highlight why and how institutional investors pivoted to fixed income ETFs during the extraordinary market volatility, and how fixed income ETFs are like a technology that can potentially offer flexibility, lower trading costs and the convenience of market access.
Use case #1: Liquidity management
Buyer: An asset manager elects to use high yield fixed income ETFs for the first time.
Background: Asset managers need liquidity to manage fund subscriptions and redemptions while remaining invested to avoid cash “drag” that can lead to underperformance. The certainty of execution matters most in assets such as high yield bonds, where transacting in individual securities can be time-consuming and expensive.
Challenge: During March 2020, extreme volatility diminished liquidity in the high yield market. Fund portfolio managers struggled to sell bonds to raise cash to meet redemption requests. At the same time, as market sentiment turned positive, it was hard to buy enough high yield bonds to keep pace with the rally.
Traditional approach: Traditionally, high yield bond fund portfolio managers created liquidity tiers, or “sleeves,” using the most liquid securities within a given asset class and cash-like instruments including money market funds.
Fixed income ETF approach: Needing to take quick action in the context of market volatility, one large asset manager purchased $250 million of HYG. It was the first time the manager had used a fixed income ETF and did so for liquidity, speed and efficiency. By using HYG in their liquidity sleeve instead of high yield bonds, this asset manager was able to access both yield and market beta while maintaining the ability to liquidate, if necessary.
Use case #2: Strategic Asset Allocation
Buyer: An insurer puts investment grade corporate fixed income ETFs at the center of their portfolio.
Background: Life insurers deal with significant premium cash flows every day. Their businesses depend on quickly and efficiently investing such cash flows at high enough yield to meet their liability obligations.
Challenge: Finding individual investment grade bonds was difficult because liquidity and new issuance dried up in February and March 2020. During this time, bid/ask spreads for investment grade bonds widened from about 25bps to over 100bps, in price terms, while LQD’s bid/ask spread stayed below 2bps over the same period.
Traditional approach: Traditionally, insurers relied heavily on individual investment grade bonds for liability matching, often by investing in newly issued bonds, which tend to be highly liquid.
Fixed income ETF approach: One major U.S. insurer was faced with the prospect of holding too much cash and earning too little income. To help remedy this mismatch, the insurer invested in the highly liquid LQD.
Use case #3: Tactical Asset Allocation
Buyer: A large public pension plan targeted emerging market fixed income ETFs in rapidly changing conditions.
Background: Public pensions must maintain diversified portfolios that can meet the income obligations of their beneficiaries. Pension managers must rapidly and efficiently adjust investment exposures in changing market conditions.
Challenge: Price dislocations in March 2020 across the fixed income markets presented opportunities to many investors in areas including emerging markets.
Traditional approach: Pension funds purchased large, liquid individual bonds or employed derivative products such as CDX in order to build desired exposure.
Fixed income ETF approach: The plan sought to rebalance its portfolio to include higher-yield seeking assets including emerging market debt, hoping to take advantage of the broad sell-off. But it was expensive and time-consuming to build this position using individual bonds, given the sharp widening in bid/ask spreads for these securities. Dislocations in the basis between physical bonds and CDX made a derivative solution less palatable as well.
In this use case, the plan opted to express its tactical market view using the iShares JP Morgan USD Emerging Markets Bond ETF (EMB), which trades nearly $600 million on an average day. By using EMB, the plan could quickly access the desired asset class while limiting transaction costs to single-digit bid/ask spreads versus several percentage points for comparable bonds. Liquidity was also a consideration as the ETF would allow them to efficiently increase or decrease the position as necessary.
Use case #4: Derivative replacement
Buyer: A large asset manager looks beyond CDX to ETFs in order to express a view on the corporate credit market
Background: Asset managers have many choices for adding or hedging credit risk in portfolios. Investment grade and high yield fund managers can choose among credit default index swaps (CDX), credit index futures, credit index total return swaps, credit ETFs or individual bonds.
Challenge: The relative merits of using one investment versus another are driven by market dynamics. The liquidity provided by CDX allows investors to rapidly add and reduce risk at scale. However, the basis risk in CDX can be substantial and correlations with cash bond portfolios can deteriorate sharply during times of stress. Credit index total return swaps (such as iBoxx TRS) typically are an improvement in basis risk and correlation, but they do not yet enjoy the same liquidity and transaction cost advantages of CDX or credit ETFs. Corporate bond index futures (e.g., CBOE HYG index futures) are still in a nascent stage.
Fixed income ETF approach: In March, the asset manager that typically used CDX to access investment grade and high yield credit exposure found that the performance differential between the synthetic exposure and individual bonds reached an untenable extreme. This manager had not previously used fixed income ETFs, but had taken note of their deep liquidity and value relative to CDX in the context of the market dislocation. Accordingly, this manager purchased $1.2 billion in LQD and $500 million of HYG to increase exposure to credit amid severe spread widening.
An eruption of market volatility in early 2020 touched nearly every corner of the fixed income markets. For institutions, the episode highlighted that the OTC bond market remains relatively opaque and fragmented, despite improvements made in recent years. By contrast, the largest and most heavily traded fixed income ETFs illustrated the important role that they play in both normal and stressed market conditions by providing invaluable price discovery and liquidity. These attributes helped institutional investors understand and navigate rapidly changing market conditions at a time when it was needed most. It also showed that the most heavily traded fixed income ETFs are essential to the functioning of healthy fixed income markets, where buyers and sellers can exchange risk efficiently.
For pensions and insurance companies, fixed income ETFs provided a means to reduce complexity and streamline portfolio construction and risk-management practices. For asset managers, fixed income ETFs served as rapid and efficient tactical allocation tools and as liquidity sleeves to minimize trading frictions and reduce the potential for holding cash to harm returns.
Recent trends underscore BlackRock’s view that institutional investors will propel future fixed income ETF growth, which remains just a fraction of total global fixed income assets. The firm projects that global fixed income ETF assets will double, to $2 trillion, by 2024, aided by the important role that fixed income ETFs are playing in the modernization of fixed income market structure, the evolution of portfolio construction and constant product innovation.
Indeed, the pace of growth could be faster than we expect. In 2019, when BlackRock first made the projection mentioned, fixed income ETF assets had just crossed $1 trillion. Since then, fixed income ETF assets have grown by more than 30% – nearly all of which was organic growth. As more asset managers and asset owners embrace fixed income ETFs as an efficient, transparent and convenient way to access the bond market – especially in times of volatility – the prospects for growth will only look brighter.