Issuers help turn bond ETFs into ‘convenient tools’

Exchange-traded fund issuers have worked hard to make bond ETFs more appealing to insurance companies, which invest heavily in fixed-income securities, and those efforts appear to be gaining traction.

“What I will give them credit for is they’ve done a lot to turn (bond ETFs) into convenient tools for insurers through working with regulators, through new product designs,” said Peter Wirtala, Chicago-based insurance strategist at Asset Allocation & Management Co. LLC, an insurer-focused investment adviser. “So, you know, anything that is ultimately useful for our clients is something that we’re going to be interested in and keeping a close eye on.”

AAM currently invests the vast majority of the equity portion of its clients’ assets in ETFs, Mr. Wirtala said. While his firm has used bond ETFs selectively, bond ETFs are unlikely to ever constitute a majority of the larger high-grade fixed-income portfolios the firm manages, something he suspects the ETF sponsors who call on him realize as well, he said.

“While I’m sure that they would love to have large insurers putting all of their general account assets into bond ETFs, I think they recognize that’s not very likely just given the sheer size of those portfolios and the ability for a skilled manager to generate outperformance that you’re not going to get with just an index-tracking passive ETF,” he said.

Still, Mr. Wirtala, whose firm manages about $29 billion for 120 clients including property and casualty as well as life and health insurers, said ETF issuers’ efforts to encourage insurance company adoption of bond ETFs — including efforts with regulators to make them easier for insurers to hold —have created “some interesting use cases” for bond ETFs.

Insurance general accounts are where ETF issuers expect to see the greatest increase in use of ETFs overall, according to survey results included in Cerulli Associates’ U.S. Exchange-Traded Fund Markets 2021 report, released in January.

Sixty-three percent of ETF issuers surveyed by Boston-based Cerulli in the third quarter of 2021 expected use of ETFs overall within insurance general accounts to increase over the following 12 months, while only 33% said the same for defined contribution plans, such as 401(k)s. Approximately 30 U.S. ETF issuers representing nearly 90% of U.S. ETF assets responded to the survey.

Equity ETFs account for the biggest overall use of ETFs among insurers, Mr. Wirtala said, adding that he doesn’t see that changing.

“It’s so widespread already, I don’t know what room remains for further adoption,” he said. “In terms of bond ETFs, I would certainly say I do expect it to increase.”

As of Dec. 31, 2020, bond ETFs accounted for about $13.0 billion of the $36.9 billion in total ETF assets held by U.S. insurance general accounts, which also included equity and other types of ETFs, according to an analysis by S&P Dow Jones Indices LLC. That was up more than 170% from Dec. 31, 2016, when bond ETFs in U.S. insurance general accounts totaled just $4.8 billion.

Over the past five to seven years, ETF sponsors have undertaken a “significant educational effort” within the insurance industry to increase awareness about bond ETFs, according to Adam Schenck, a Chicago-based principal and managing director at Milliman Financial Risk Management LLC, which subadvises about $6.6 billion in assets for Transamerica DeltaShares and Innovator ETFs.

“There have been concerns that have had to be allayed related to volumes in volatile periods, liquidity and spreads, but those myths have been debunked by action through ETFs’ track records as much as any words,” he said in comments emailed to Pensions & Investments.

State insurance regulators gradually came to recognize bond ETFs’ “mature and successful” track records as well, and “their stamp” played a key role in getting ETFs to where they are in insurers’ portfolios, said Mr. Schenck, who described 2017 accounting guidance issued by the National Association of Insurance Commissioners, the U.S. standard-setting organization for the insurance industry, as a “watershed moment.”

In 2017, the NAIC decided to adopt “systematic value” as an option for accounting for NAIC-designated fixed-income ETFs, according to a 2021 State Street Global Advisors’ paper on the topic. Systematic value is a “modified amortized cost accounting method which will allow fixed-income ETFs to more closely mirror the effective interest method applied to individual bonds,” SSGA’s paper said, adding that the development was “an important step towards increased adoption of fixed-income ETFs.”

Mr. Schenck also cited a recent move by the New York State Department of Financial Services. DFS, in a regulation effective through Jan. 1, 2027, said shares of a fixed-income ETF can be treated as bonds, as opposed to equity, for the purpose of a domestic insurer’s risk-based capital report if the fund meets certain criteria, including requirements that the ETF tracks a bond index and has at least $1 billion in assets under management.

“Equity has a much larger capital charge than bonds do,” AAM’s Mr. Wirtala said. “So, it’s a big difference, and insurers, if an asset is fundamentally bond-like, they would certainly prefer to have it treated as a bond for these purposes.” If bond ETFs must be treated as equity, “it’s very hard to justify holding them,” he said.

“The fact that now they’re essentially bonds for all intents and purposes does create some interesting use cases for them that would not have otherwise been so compelling,” Mr. Wirtala added.

For example, property and casualty insurers in disaster-prone areas tend to hold more cash than similar companies in case they need to pay out claims quickly, he said. A bond ETF would enable such firms to earn a market return while also being able to liquidate with just one trade, as opposed to the many more trades required to liquidate a bond portfolio that offered similar market exposure, he said. Bond ETFs also could potentially prove a useful tool for very small insurers or those in the start-up phase that may not have enough assets yet to justify the cost of a separate account with an asset manager like AAM, Wirtala said.

“Regulatory change is definitely important” in enhancing the appeal of bond ETFs, Mr. Wirtala said.

ETF issuers like BlackRock Inc., The Vanguard Group Inc. and SSGA would appear to agree, as indicated by the letters each submitted to DFS last fall regarding the then-proposed DFS regulatory change.

In an Oct. 6, 2021, letter to DFS expressing its support for the proposed regulation, BlackRock said bond ETFs have “transformed the way that many institutional investors access the corporate and government bond markets” and that many investors see them as “a complement to, or a direct substitute for, individual bonds.”

Bond ETFs are “key investment and risk management tools that may function more efficiently than individual bonds, particularly during periods of market stress,” the letter said, a strength that the letter said was demonstrated during the COVID 19-related market volatility of March 2020.

Big ETF issuers — particularly BlackRock, which managed $715 billion in fixed-income ETFs globally as of March 4 — have put in a lot of effort with regulators to help make bond ETFs more appealing to insurers, according to Ben Johnson, Chicago-based director of global exchange-traded fund research for Morningstar Inc.

BlackRock declined to comment beyond its letter.

“ETF issuers have every incentive to sell more ETFs,” Mr. Johnson said. “So, they are going to kick down every door they can kick down. Of course, they are going to knock politely first.”

The insurer market is “a meaningful market, specifically for fixed-income ETFs,” he said.

For insurers, “it’s all about asset-liability management and cash flow and liquidity needs,” said Gregory H. Cobb, vice president, investment strategy at Sage Advisory Services, Ltd. Co. , an independent investment advisory firm with more than $17 billion in assets under management or advisement.

“And you really can’t do asset-liability management very well with equities,” said Mr. Cobb, who is also director of insurance solutions at Austin, Texas-based Sage
Advisory.

A portfolio of individual bonds allows insurers to own securities that have cash flows and maturities tailored to match the insurers’ expected cash flows and liability streams, Mr. Cobb said.