On Sept. 10, Laurence D. Fink, BlackRock Inc. chairman and chief executive officer, told an audience at the Barclays Capital Financial Services Conference in New York how BlackRock worked with an unidentified large pension fund to shift 4,000 individual bond issues into four iShares ETFs plus cash. “I believe this is going to transform the fixed-income market,” said Mr. Fink.
Mark Wiedman, BlackRock managing director and global head of iShares, revealed at Morningstar's ETF Invest conference on Oct. 4 in Chicago that the trade in question constituted $1.4 billion of fixed-income securities.
According to market analysis from iShares in July, fixed-income ETFs have only captured 0.3% of the global underlying market value in fixed income, compared to 2.2% in equity ETFs. Moving that even fractionally higher means larger swaths of fixed-income securities consolidated inside ETFs and fewer held directly on the books of institutional investors.
That syncs with the trend in the primary dealer market, particularly for corporate bonds. A September study by TABB Group noted “a dramatic secular change” in which “dealers have pulled back from providing liquidity in the cash market.” Federal Reserve Bank of New York data show that primary dealer inventory in corporate bonds is less than $50 billion, levels not seen since 2003, and far below the 2008 peak of $250 billion.
More assets in bond ETFs has also led to what some believe are pricing distortions, not uncommon for equities in index funds, but relatively new for bonds. For example, the $12 billion SPDR Barclays High Yield Bond ETF (JNK) and the $17 billion iShares iBoxx $ High Yield Corporate Bond ETF (HYG) have been linked to higher prices and greater volatility in certain bonds, says the TABB study as well as a recent report from Goldman Sachs entitled “Assessing the Impact of ETF Flows on Credit.”
Vince T. Lowry, chairman of VTL Associates LLC in Philadelphia, advises caution when it comes to bond ETFs outside of U.S. Treasury funds.
“When rates rise, where are the fund redemptions going to go?” says Mr. Lowry, whose firm is a consultant to defined benefit plans and is also the adviser to RevenueShares ETFs. He hearkens back to phases of bond market illiquidity “when the bids drop,” particularly for mortgage-backed securities in 1987, 1994 and 1999 — not to mention 2008 — and believes dealers will be less willing or able to process significant in-kind redemptions in corporate or high-yield bond ETFs.
Cambridge Associates' Ms. Farquhar notes that one impediment for pension fund investors is the “perception that a high concentration of retail investors (in ETFs) increases the risk of a run on the product, compounding pricing pressure in a stressed market.”
Yet the ability to participate with retail through trading is also an advantage over bonds in a normal market.
Daniel Gamba, managing director and head of Americas institutional iShares for BlackRock in New York, said that before the unidentified pension fund moved into bond ETFs, it “had to see that liquidity of the ETFs was persistent.”
Sourcing that liquidity — to enable institutional investors to get in or out of an ETF position — is still not as simple as checking the book and placing a trade, as it would be in an individual bond or listed stock. Large transactions are best handled through an ETF market-making desk which will walk investors through the impact and total cost of a trade. n