Bond ETFs hit $1 trillion, now set for takeoff

Global assets under management in bond exchange-traded funds passed the $1 trillion mark for the first time during the quarter ended June 30, and industry sources are confident assets will double over the next five years, possibly sooner, thanks to increasing demand across the investor spectrum.

Industry sources said AUM invested globally in bond ETFs is poised to grow exponentially as pension funds, endowments, money managers, wealth managers and registered investment advisers continue to shift assets to passive management and expand their use of fixed-income ETFs as building blocks in portfolio construction.

Global AUM invested in a wide range of bond ETFs totaled $1.05 trillion as of June 30, up 473% over the 10-year period, data from Morningstar Inc. showed. By comparison, $4.26 trillion was managed globally in equity ETFs as of June 30, up 456% in the decade.

"Bond ETFs were created to give individual investors easier access to bond markets, but they are increasingly being used as a tool by institutional investors, who have really pushed the growth of bond ETFs. Further growth is inevitable," said Kevin C. McPartland, managing director and head of market structure and technology at researcher Greenwich Associates Inc., Stamford, Conn.

Institutional users of bond ETFs include the $372.8 billion California Public Employees' Retirement System, Sacramento; the $57.2 billion Pennsylvania Public School Employees' Retirement System, Harrisburg; and the $28.3 billion Employees Retirement System of Texas, Austin.

Demand for bond ETFs is high among asset owners, according to a Greenwich survey of 181 U.S. institutional investors conducted in the fourth quarter of 2018. The survey universe totaled 181 respondents, 37 of which were from pension funds, endowments and foundations and 33 were from insurance companies or insurance company asset management units. BlackRock Inc. sponsored the research for the report.

Survey results showed that 60% of respondents said they currently invest in bond ETFs, compared to 20% in 2017. Of respondents who currently invest, 42% intended to increase their allocations this year.

As U.S. institutions continue to shift more assets into passively managed strategies, including bonds, 78% of respondents to Greenwich's survey said ETFs are their preferred vehicle for indexed assets within their portfolios.

Among the most common uses of bond ETFs by asset owners are tactical adjustments, rebalancing, completion strategies, liquidity and transition management, cash equitization and risk management/overlay management, said Phillip R. Nelson, partner and director of asset allocation at investment consultant NEPC LLC, Boston.

"Trading physical bonds — especially high-yield and credit bonds — has become more difficult in the last 15 years" as bond market liquidity declined, making it harder for asset owners to build bond portfolios, Mr. Nelson said, noting that ETFs offer "a quick way" to get exposure.

Mr. Nelson said NEPC consultants are "agnostic about advising clients on accessing bond market beta. We urge them to find the best implementation tools for their portfolios and depending on the situation, ETFs may be the best option."

Asset owners are tapping ETFs to implement a variety of portfolio exposures.

Susan E. Oh, director of risk parity, currency hedging and strategy implementation for Pennsylvania Public School Employees' Retirement System, said ETFs "have a great role" in the fund's $4.6 billion risk-parity portfolio. "I thought it was a brilliant idea to use an ETF in the portfolio in part because of the cost savings compared to buying individual bonds," she said.

Within the $2.3 billion internally managed portion of the risk-parity portfolio, Ms. Oh uses a combination of futures, swaps, direct bond investments and ETFs.

In running the global inflation-linked bond sleeve within the fund's risk-parity allocation, Ms. Oh relies on BlackRock's TIP Bond ETF to provide exposure to U.S. inflation-protected bonds with low transaction costs. As of June 30, PennPSERS' has $236 million invested in the TIP ETF, which is also used for rebalancing within the portfolio.

Direct investment in 30-year U.S. Treasury-inflation protected bonds provides additional exposure to the U.S. bond market while exposure in the global bond portfolio to non-U.S. inflation-protected bonds is achieved through swaps, she said.

PennPSERS also uses ETFs to equitize cash within the global equity sleeve of the risk-parity portfolio and had $450 million invested in equity ETFs as of June 30.

As more asset owners add and increase investment in bond ETFs, it's possible that global AUM in bond ETFs may reach the $2 trillion mark in less than five years, said Stephen Laipply, managing director and head of BlackRock's U.S. iShares fixed-income strategy, based in San Francisco.

Mr. Laipply said continued growth is likely, based on current trends, particularly in portfolio construction.

Bond ETFs offer investors "pure market beta" that can encompass an entire fixed-income portfolio or partial exposure, for instance to high-yield bonds in a single liquid, transparent ETF rather than having to purchase hundreds of individual high-yield bonds, Mr. Laipply said. BlackRock is the world's largest money manager with $6.84 trillion in assets under management as of June 30. The New York-based firm also is the largest ETF manager with a total of $2.01 trillion as of the same date, of which $513.8 billion is managed in bond ETFs.

Leighton A. Shantz, senior managing director and director of fixed income for Texas Employees' Retirement System, uses five ETFs to manage about 11% of the fund's $3.1 billion credit portfolio of which 84% is managed internally.

"I view ETFs as tools which are great complements to traditional fixed income and allow me to tactically tilt the portfolio pretty easily," Mr. Shantz said.

Most of the credit portfolio is invested in individual high-yield bonds with the balance – $375 million – invested in ETFs which Mr. Shantz said are managed actively on the portfolio level to control exposure to high-yield markets.

In addition to using ETFs to manage tactical exposure shifts within a particular asset class, institutions increasingly are using ETFs for larger transition projects.

In what's known as a transfer of assets deal, institutional investors increasingly are handing their bond portfolios to a broker/dealer, which transfers the bonds to an ETF in which the investor then invests, said William R. Ahmuty, managing director and head of the SPDR fixed-income group at State Street Global Advisors, Boston.

The advantage for the asset owners is the simplicity of transferring the assets to the ETF in one move rather than selling thousands of bonds individually and incurring high trading costs, Mr. Ahmuty said, noting "selling several hundreds of millions of bonds is not easy."

Post-transfer, an asset owner has a similar bond portfolio within a single liquid, transparent portfolio and "goes from owning the bonds to owning the ETF," Mr. Ahmuty said.

Texas Employees was among the first asset owners to accomplish a transfer of a core bond portfolio to fixed-income ETFs in 2013 (Pensions & Investments, July 21, 2014).

Mr. Ahmuty said there's been an uptick in the number of institutions completing transfer of assets deals, particularly as part of transition management from one asset class to another. He said he could not identify investors that have worked with SSGA on this type of deal.

SSGA had $2.92 trillion in assets under management as of June 30, including $661 billion of assets invested in ETFs of which $69.3 billion was in bond ETFs.