The advent of exchange-traded products focused on fixed income has been swift and surprising, according to a report from the BlackRock Investment Institute.
According to the report, financials dominate investment grade ETPs with a 39 per cent share, this is almost triple the level of the next biggest group, consumer non-cyclicals.
High yield ETPs hold a more diverse bag of bonds, with communication firms the largest share in the sector at just over one fifth
Brazil, Mexico and Russia are the top three countries held by emerging market debt ETPs.
Index membership is the determining factor for ETPs, not an assessment of the debt itself. Of the 11 emerging markets ranked in the top 25 countries of the BlackRock Sovereign Risk Index (BSRI), only three – South Korea, Russia and the Philippines – feature in the ETP top 10 list.
Foreign exchange fluctuations can make all the difference in total investment return. Foreign currency appreciation furnished 60 per cent of total returns of emerging market debt in the past eight years but contributed 75 per cent of the risk.
Emerging market debt ETPs hold about one third in local currency bonds and the remainder in US dollar debt, although this differs by country.
Data over the last four years suggests that when yields rise, the impact on overall ETP flows has been scant, although inflows slowed in the most recent period.
Yield spikes do influence interest rate-sensitive sectors such as US Treasury ETPs, but so far credit sensitive ETPs have been less affected.
ETP volumes are small compared with the overall value of trade in the underlying bond markets, but they are more vibrant than the trading in many individual issues. For example, a quarter of high yield bonds trade just one to five days a month.
Exchange trading almost tripled in emerging market debt and high yield, and doubled in investment grade, over the last three years.
Volumes of bond ETPs have risen sharply, but liquidity in underlying markets is spotty. Contrary to popular belief, much of fixed income ETP trading does not necessarily trickle through to the OTC bond markets.
Fixed income ETPs should be viewed as investor sentiment indicators rather than market forces as they are a drop in the bucket compared with the total value of bonds outstanding. Of all the sectors in bond market, it is in high yield where ETPs have the highest share of the market, and that still stands at just three per cent.
