Assets under management in fixed income exchange traded funds are set to hit more than US$2trn by 2025, almost four times current levels, according to BlackRock.
Data from the buyside firm, which is the most active issuer of ETFs through its iShares platform, show that global fixed income ETF assets stood at US$576bn at the end of April. While that represents just 0.5% of outstanding cash bond volume, growth has been running at a record rate with almost US$44bn flooding into the products in the first quarter. BlackRock’s iShares accounted for the largest portion of that activity with inflows of almost US$28bn into its bond ETFs.
“This year is a critical tipping point for fixed income exchange-traded products to reach our projected milestone in the next nine years,” said Brett Olson, head of fixed income for iShares, EMEA.
“US$2trn is a big number, but given the trajectory in the marketplace, we can see that happening.”
A recent survey from Greenwich Associates found that around 70% of bond ETF users cited liquidity benefits as key to their investment decision, alongside ease of use and “single-trade diversity”.
Greenwich notes that bond ETF liquidity has grown at an annual rate of over 30% since 2008, based on annual trading volume of US listed instruments. At the same time, banks’ corporate bond inventory has dropped to almost zero in response to new capital and leverage rules, falling from a peak of US$286bn in 2007, according to data from the New York Federal Reserve.
The flight to liquidity was illustrated in the first quarter as fixed-income investors shifted into ETFs in response to wider market trends.
Risk off
The first six weeks of 2016 were dominated by huge inflows into government bond ETFs reflecting the broader risk-off environment. More than US$12bn flowed into Treasury ETFs, with much of that activity coming from riskier assets such as high yield, investment grade credit and equity funds.
“Active managers are looking at ETFs to build a moat around the portfolio”
As market sentiment calmed from mid-February, however, the provider’s benchmark iBoxx US$ High Yield Corporate Bond ETF (HYG) saw assets jump by almost 50% to hit more than US$17bn by the end of April, driven by price outperformance and fund inflows.
“Investors bought HYG as a tool to participate in the rally as it was hard to find individual bonds in the secondary market and primary issuance was quite tame,” said Matthew Tucker, head of the iShares fixed income strategy team.
That reversed as primary issuance gathered pace, and HYG saw more than US$3bn of outflows over just six days.
Active liquidity buffer
As well as representing a liquid access tool for maintaining market beta, ETFs are also seeing increased interest from pension funds looking to bridge the gap when they move assets from one active manager to another.
Some active mutual fund managers are also beginning to use the products as liquidity buffers to protect alpha in the event of withdrawals.
“Active managers are looking at ETFs to build a moat around the portfolio,” said Tucker. “Owning ETFs as part of the portfolio means that if there are withdrawals, fund managers can redeem the ETF rather than sell the bonds. They are concerned that if they sell bonds, they might not be able to buy them back.”
A persistent low rate environment is expected to be a significant driver of demand as investors turn to longer dated and lower quality assets as well as more cross-border securities in order to meet their return requirements.
“Investors now have to go out seven or nine years in German bunds just to find yield. It’s a real challenge for those using fixed income as a safe haven,” said Brett Pybus, iShares’ European head of fixed income product strategy.
“ETFs give a lot of variety for sourcing yield and building portfolios. We’re still in a world where investors need income and yield and we don’t see it getting any easier. Clients need to have a different tool in the tool kit.”
Europe remains some way behind US developments with US$142bn of assets in bond ETFs at the end of April compared to US$385bn in the US. That largely reflects wider trends in the equity ETF market where European assets stand at just US$345bn compared to US$1.75trn across the Atlantic.
With compulsory Trace reporting, US bond ETFs benefit from an additional layer of transparency that is not yet available in Europe, but that could change as a result of the Markets in Financial Instruments Directive that becomes effective in January 2018.
Options
BlackRock is also working closely with market participants to develop a listed options market. Large US bond ETFs like HYG already see active on-exchange options trading, but European activity has so far been done on an over-the counter basis.
The first step has been the development of an ETF lending market, which has now seen US$9bn of bond ETF assets made available to borrow.
“The development of an options market brings in some of the levered accounts and takes the product into other types of portfolio,” said Pybus.
