Fixed-income exchange-traded funds are having their moment.
Just as the global financial crisis was a flashpoint for a major shift into equity index ETFs, March 2020 has emerged as the fixed-income equivalent.
Spurred first by market volatility, then by the Federal Reserve's support for corporate credits, fixed-income ETFs saw $96 billion of net inflows in the first half of the year compared to $75 billion for the first half of 2019, according to FactSet Research Systems Inc. More than half of those flows went to corporate investment-grade and high-yield bonds specifically targeted by the Fed's Secondary Market Corporate Credit Facility.
"The change in mindset is measurable," said Reginald Browne, principal at market-making firm GTS in New York.
The Fed's use of ETFs as a mechanism to support corporate credit only instilled further confidence in the $956 billion U.S. fixed-income ETF market.
In a recent paper, BlackRock said it observed "over 60 asset owners and asset managers that were first time buyers of iShares fixed income ETFs in the first half of 2020," adding "about $10 billion in assets." These investors were undeterred by a period of volatility in March when trading spreads of some of the largest and most liquid ETFs widened several basis points beyond their historical averages.
"Once the market understood that there would be a natural buyer, ETF spreads began to tighten," Mr. Browne said. "In fact, the most significant impact we saw on ETF trading after that was the relative scarcity of bonds needed to create new ETF shares."
Demand for ETFs pulled premiums through to the underlying bonds and contributed to the shifting of borrowing rates downward. In the second quarter, U.S. investment-grade corporate bond issuance totaled $736 billion, more than 2.5 times the amount raised in the same quarter of 2019, according to the Securities Industry and Financial Markets Association.
From May 12 to June 30, the Federal Reserve, through BlackRock as its agent, built an $8 billion portfolio of 16 ETFs. It also purchased $1.3 billion in individual bonds on the secondary market.
According to Elisabeth Kashner, director of ETF research at FactSet, the Fed's ETF portfolio includes all but one of the eligible segments' investment-grade or high-yield ETF that had more than $1 billion in assets as of March 31, excluding bullet maturity ETFs. In line with the terms of the investment agreement, BlackRock products comprise 49% of assets, moderately below its broad market share in both product categories.
While the largest holding in the portfolio is the iShares iBoxx US Dollar Investment Grade Corporate Bond ETF, a $57 billion category-leading fund known by its ticker LQD, a conspicuous concession is apparent in the high-yield portion of the portfolio. Fifty-four percent is held in funds managed by State Street Global Advisors, though BlackRock's $28 billion iShares iBoxx USD High Yield Corporate Bond ETF is the largest in its category.
"The Fed has been discreet in its purchases," said Bill Ahmuty, head of the SPDR fixed-income group at State Street Global Advisors. Though the Fed may be in the market, its trading strategy isn't disruptive. Yet areas where the Fed is not focused — longer-term corporate debt and senior loans, for example — have seen less investor activity and even outflows. According to FactSet, floating-rate ETFs experienced more than $7.5 billion in net outflows in the first half of 2020.
"We've also seen the 5- (and) 10-year curve steepen for corporates," said Mr. Ahmuty, citing the Fed's focus on debt maturing in less than five years.
For newcomers to ETF trading, Mr. Ahmuty said SSGA has had to stay in front of investors on education. If anything, the March volatility, which pushed ETF trading spreads out significantly and caused a lot of ETFs to show closing prices at unusual discounts, then premiums, to net asset value, revealed the challenges of third-party-derived prices for bonds that rarely trade. Mr. Ahmuty said a client said to him, "I would love to buy these ETFs at a discount but I can't sell the bonds where they are marked."
Paul Van Gilder, fixed-income portfolio manager at the $11 billion Municipal Employees' Retirement System of Michigan, said MERS had been in the process of shifting from an internally managed portfolio of bonds to a $2.6 billion portfolio that is predominantly ETFs.
Given that shift, during March and April volatility, MERS was able to add emerging market debt exposures through ETFs and sell high yield on the strength of the Fed announcement.
"ETFs provide a level of safety through secondary market liquidity," said Jeffrey Baccash, director and head of global ETF solutions for BNP Paribas. "They also provide a window into less-frequently traded bonds and where investors think the prices should be."
It remains to be seen how fixed-income ETF newcomers and others boosted by the Fed's confidence in the market will react when the Fed exits. "There's been no clear guidance on an exit strategy," SSGA's Mr. Ahmuty said.
The program terms call for the secondary market facility to cease purchasing bonds and ETFs on Sept. 30. But just as the Fed's rescue during the global financial crisis continued for years, it seems almost as likely that the Fed will be in this market for a while, too.
