Of the $335 billion invested in U.S.-listed unleveraged fixed-income exchange-traded funds, $156 billion has entered the funds in the past five years, according to research from XTF Inc., New York.
Such spectacular growth, compared with more established equity ETFs welcoming about one-third of total assets in the same span, has come despite some significant handicaps that have largely kept institutional investors away from all but the largest offerings.
But with investors adjusting to the post-financial crisis realities of debt-market liquidity, fixed-income ETFs might prove a useful tool in adjusting exposures and moving portfolios, and even serving as long-term core holdings for smaller institutions.
Julie Barranco, director of fixed income for the Retirement Systems of Alabama, Montgomery, said the RSA uses fixed-income ETFs “for some of the smaller funds that we manage.”
“Oftentimes their cash balances grow and it is hard to find small lots of fixed-income securities,” said Ms. Barranco. “When these occasions arise, we sometimes purchase a fixed-income ETF such as Vanguard Total Bond Market or iShares Investment Grade Corporate Bond to fulfill these investment needs.”
Despite the growing use of a wider swath of fixed-income ETFs by retail investors and intermediaries, fund and market dynamics concentrate the interests of large institutions to just a handful of offerings.
Peter Ehret, who manages a $1.1 billion high-yield portfolio for the Employees Retirement System of Texas, Austin, said size and liquidity aren't there for some of the ETFs that he might consider, even in transitions or tactical allocations.
Despite the availability for large holders of ETFs to trade in and out by working with market makers and authorized participants, the Roach Motel syndrome of not being able to execute in the secondary market persists.
Some of these challenges can be overcome by an increasingly vibrant market for ETF options and derivatives, and the inertia of greater flows. Consider how color commentary adds to the fabric, context and understanding of a televised sporting event or political debate.
According to data from FactSet Research Systems, 22% of unleveraged fixed-income ETFs have listed options available and only eight have open interest greater than 10,000 contracts. Another factor that indicates ease of use for large investors is daily share trading volume of the ETF relative to a creation unit (the number of shares represented by a creation/redemption basket).
For a majority of products, creation units are 100,000 shares or higher and the median for all fixed-income ETFs of creation units per day traded is 0.22 over a 45-day period, according to FactSet. Among the most liquid fixed-income ETFs are the iShares iBoxx $ Liquid High Yield ETF and the iShares 20+ Year Treasury Bond ETF, both trading about 80 times a creation unit. Next are SPDR Barclays High Yield Bond and iShares iBoxx $ Investment Grade Corporate Bond, at 45 and 30 times, respectively.
Institutional size can also arrive in products that offer even more specialized exposure, such as bank loans or emerging market bonds, where investors can coordinate with market makers to effect trades, said Scott Eldridge, director of fixed-income product strategy for Invesco PowerShares in Downers Grove, Ill.
For example, in early September, a $100 million midday trade of PowerShares Senior Loan was negotiated in the secondary market.
David Krein, head of research for MarketAxess Holdings Inc. in New York, has considered how money managers can make fixed-income ETF products more successful. He thinks that “one way to encourage fixed-income ETF trading is with smaller create/redeem baskets that provide more flexibility to create better primary market liquidity.”
“Fixed-income ETFs don't have the size and scale needed for that category of institutional investor,” said Mr. Krein. “Plus, those investors tend to think in bond-specific risk terms to match their liabilities, whereas many ETFs do not have equivalent metrics such as maturity.”
This concern is not uncommon for investors who are used to analyzing specific fixed-income securities. ETFs, which are traded on equity exchanges and quoted by price, do not match up. Recently, however, Bloomberg LP, working with BlackRock Inc.'s iShares and State Street Global Advisors, has begun to publish yield and spread metrics for fixed-income ETFs to allow trading desks and investors to better understand the expected cash flows of the underlying bonds and credit risk for these baskets of securities.
“We want institutional investors to be able to evaluate these products using traditional bond analysis,” said Dave Mullen, fixed-income product manager for Bloomberg in New York. n
