Investors turn to ETFs to sidestep illiquidity in bond market

Investors are putting record amounts of money into exchange-traded funds as bonds become increasingly difficult to buy and sell.

Global fixed-income ETFs, which track bond indexes and trade like stocks, attracted $60 billion of inflows this year through May 25, according to data compiled by BlackRock Inc. That's the most for the period since the funds were created 14 years ago and on pace to top last year's record total of $93.5 billion.

The funds are emerging as one of the few winners from worsening trading conditions as dealers pull back from making markets and investors seek cheaper ways to take and hedge credit exposure. Liquidity and ease of use are the top reasons given by about 70% of bond ETF users, according to a report by Greenwich Associates.

“Record inflows tell us fixed-income ETFs have an even bigger role to play going forward,” said Allan Lane, London-based managing partner of Twenty20 Investments LLP. “With one click you can access the whole market. It seems there's no stopping them.”

Fixed-income ETFs manage about $576 billion of global assets, ranging from Treasuries to high-yield corporate bonds and emerging-market debt. BlackRock, the biggest provider of the funds, started Europe's first ETF for mortgage-backed securities last month.

The funds allow investors to access markets they may not otherwise be able to, said Peter Sleep, a London-based senior money manager at Seven Investment Management LLP, which oversees about $10 billion.

“Ten years ago, I'd never invested in high-yield or emerging-market debt or convertible bonds,” Mr. Sleep said. “I came into those through buying ETFs.”

Though ETFs remain a small part of the $1.3 trillion high-yield market, they're gaining in popularity. BlackRock's $15 billion iShares iBoxx $ High Yield Corporate Bond ETF, the largest for high-yield debt, averaged 14 million shares a day in trading this year through May 27 — more than triple its volume two years ago.

“It's an easier way to deploy excess cash than buying bonds,” said Anthony Robertson, head of global leveraged finance at BlueBay Asset Management in London, which oversees $58 billion. “If we bought bonds, we would run the risk of not being able to sell them at a later date because they're illiquid.”

Trading costs are lower for high-yield ETFs than for junk bonds, according to CreditSights. The average difference between the prices at which traders buy and sell the iShares Euro High Yield Corporate Bond UCITS ETF is 0.17 percentage points, according to data from Bloomberg and CreditSights. That compares with an average gap of 0.92 percentage points for euro-denominated securities with the three highest junk ratings, the data show.

While it's easy to buy ETFs, concern is growing that it may not be as simple to get out when sentiment sours. Federal Reserve Bank of Dallas President Robert Kaplan and Oaktree Capital Group LLC's Howard Marks are among those warning that investors may be underestimating the difficulty of exiting the investments.

Investors who are already paying active managers may also balk at the additional fees associated with the funds. For some investors, those may outweigh the benefit of lower transaction costs, according to David Watts, a credit analyst at CreditSights in London.

“Active managers are concerned that it doesn't look good if they're outsourcing funds to a passive manager,” he said.

There will be a "massive shift" into passive investing amid consolidation in the asset management industry, BlackRock's Laurence D. Fink said at a conference on Tuesday. Active fund managers are struggling to beat benchmarks, sending disappointed investors into low-cost index funds.

Investors are increasingly using the funds as a liquidity buffer for core debt holdings. They're buying and warehousing ETFs when there's a dearth of new bond offerings and selling them to get cash for new issues when primary markets restart, Mr. Watts said.

That was highlighted last month, when investors redeemed about $3.6 billion from BlackRock's U.S. high-yield ETF in six days as the pipeline for high-yield offerings grew, according to the asset manager.

“Investors are using them for tactical allocations like a transition vehicle,” Mr. Watts said. “They want funds available if they need them, without having to take the pain or distortion of selling individual bonds.”

Investors stepped up their use of fixed-income ETFs to express negative views on debt markets this year. Short positions on European bond funds exceeded $1 billion for the first time in February, though they've since fallen to about $361 million, according to Markit Ltd.

The funds are also emerging as an alternative to credit-default swaps amid concerns the primary hedging tool of the past decade is becoming less effective.

“We used to use credit derivatives to hedge, but we found the indexes were not correlated very closely with the bond market,” said Olivier de Parcevaux, a high-yield fund manager at Butler Investment Advisors SAS in Paris, a total-return hedge fund with &euros;200 million ($223 million) of assets under management.

Mr. Parcevaux, whose firm has tripled its use of bond ETFs since starting to trade them in 2011, also uses them in arbitrage trades against total-return swaps, another type of derivative used to wager on corporate bonds.

“Bond ETFs have become like whales in the market,” said Regina Borromeo, a London-based money manager at Brandywine Global Investment Management, which oversees $70 billion of assets. “They're only going to get bigger as bond market liquidity worsens.”