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CFRA cites diminished liquidity behind demand for fixed income ETFs

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Todd Rosenbluth, Director of Mutual Fund & ETF Research with CFRA has commented on liquidity and fixed income ETF offerings.

Rosenbluth (pictured) writes that although fixed income offerings represent 17 per cent of the ETP market, the category’s USD63 billion of net inflows year-to-date through 7 September were a 36 per cent share. 

“Despite recent interest rate hikes (as well expectations for additional hikes in the future), demand has swelled for low-cost, liquid vehicles for core and tactical bond allocations. The latest Greenwich Associates Fixed Income ETF study of institutional investors serves as a reminder that there’s still room for additional growth,” Rosenbluth writes.

“Fixed income ETFs comprise just 1.4 per cent of the overall fixed income market as of June 2018, but there remain persistent liquidity concerns for these funds. This summer, Howard Marks, co-chairman of hedge fund Oaktree Capital, mused about the probability that in a crisis a high-yield bond ETF will not be more liquid than the underlying bonds. Yet, according to Greenwich, diminished liquidity in global bond markets, due in large part to increased bank capital requirements, is fuelling demand for fixed income ETFs among institutional investors.

“An unidentified portfolio manager from a US wealth management firm told Greenwich ‘finding good-quality fixed-income instruments that fit the criteria that I look for is one of my biggest challenges’.  Most Greenwich study participants said it has become more difficult to execute large bond trades over the last three years. Not surprisingly, more than half of the institutions have increased their use of ETFs in the same period and a similar percentage hold at least four fixed income ETFs in their portfolios.”

Rosenbluth writes that unlike an individual bond, a fixed income ETF trades on an exchange with price transparency. “The standardisation of the bonds inside the portfolio, based on well-defined criteria, further supports the liquidity benefits. Meanwhile, unlike a fixed income mutual fund, there are no forced redemptions with an ETF and bid/ask spreads have tightened during prior periods of bond market volatility.”

Greenwich noted that the internal guidelines and external regulations that limit the use of ETFs at institutions are gradually disappearing. 

“Indeed, in April 2017, the National Association of Insurance Commissioners revised its methodology for accounting of fixed-income ETFs. A new systematic valuation method allowed insurers to treat ETFs more like ordinary bonds, which has the potential to reduce the volatility in the company’s balance sheet and income statement.

“In 2017, insurance companies increased their assets in fixed income ETFs by a whopping 69 per cent according to S&P Global. Assets held by insurers in iShares iBoxx USD Investment Grade Corporate Bond ETF (LQD) more than doubled to USD3.6 billion, making it the largest ETF in insurance company asset bases, while iShares MBS ETF (MBB) ended 2017 with USD230 million, a five-fold increase from the year before.”

Rosenbluth writes that CFRA thinks that as insurance companies become more comfortable with the new accounting treatment, usage of bond ETFs will climb considerably higher.

“Indeed, ETF allocations have grown to approximately 18 per cent of USD28 billion in total fixed-income assets among the 87 institutions Greenwich spoke with, with 80 per cent citing “liquidity/low trading costs” and 78 per cent choosing ‘easy to use’ as reasons for using bond ETFs.”

CFRA has research on 63 fixed income ETFs that trade more than 250,000 shares daily and 138 that traded with a bid/ask spread of USD0.03 or less as of 10 September. 

Rosenbluth cites examples of funds that meet both criteria, including iShares Core US Aggregate Bond ETF (AGG), SPDR Bloomberg Barclays High Yield Bond (JNK), VanEck Vectors JPMorgan EM Local Currency Bond (EMLC) and Vanguard Short-Term Bond Index ETF (BSV), as well as LQD and MBB. “In rating more than 200 fixed income ETFs, CFRA incorporates a fund’s liquidity and trading costs and combines them with a review of the risk-reward characteristics of the portfolio.

“This is helpful as while 53 per cent of surveyed institutions are applying bond ETFs to provide passive exposure in the core of the portfolio, an even greater 60 per cent are using bond ETFs for tactical allocations. According to SSGA, while aggregate bond ETFs gathered USD32 billion of net inflows in the 12-month period ended August, lower-risk inflation-protected and higher-risk emerging-market bond ETFs gathered USD7.2 billion and USD4.1 billion of new money.”

“Both retail and institutional investors continue to embrace bond ETFs as an easy-to-access alternative to the bond market, which has grown increasingly illiquid,” explained Karen Schenone, Fixed Income Product Specialist within BlackRock’s Global Fixed Income Group. “When investors want to put cash to work quickly and efficiently, they are increasingly using bond ETFs.”

US institutional investors surveyed by Greenwich currently owning fixed income ETFs targeted expanding their ETF allocations by almost 30 per cent. 

Rosenbluth concludes: “While we think advisors and retail investors focus more on expense ratio, as demand grows at investment managers, insurance companies and other institutional investors, it will lower the trading costs and improve the liquidity for all users of bond ETFs. This circular effort will cause the fixed income ETF pie to expand further.”

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