Mutual fund managers, pension funds and registered investment advisers have been turning increasingly to exchange-traded bond funds to protect them should fixed-income markets turn nasty. Since May managers have been able to test the theory that ETFs allow them to better maneuver illiquid and volatile markets. That was the month, of course, when Federal Reserve chairman Ben Bernanke signaled to the markets for the first time that the Fed was preparing to taper its $85 billion in monthly bond purchases, which have kept interest rates at historic lows and fired up international markets. Bernanke’s remarks sent rates rising, bond prices plunging and investors redeeming their bond funds. Though the Fed has since announced a delay in tapering until there are more signs of solid recovery, the bond markets remain in flux. (Read more: “Investors Hinge ETF Strategy on Fed Tapering Timing”)
While investors’ unease complicates matters, the added volatility stresses the market trading structure for fixed-income securities. Bonds still primarily trade hands in a principal-based market that requires dealers to commit capital to facilitate trading. But a combination of new regulations, stricter capital requirements and risk aversion has prompted banks to pull back from the business of fixed-income trading. To get around hobbled bond markets, investors have been using ETFs, mostly indexed funds in asset classes such as high-yield and investment-grade corporate bonds. ETFs — which trade on a regulated exchange, have full price transparency and are highly liquid — have become a viable alternative to buying and selling individual bond issues that may not trade easily, particularly during times of stress. They also offer investors the flexibility to dial up or down their exposure to broad sectors of the fixed-income markets.
ETFs, in theory, should have dampened liquidity problems this year. BlackRock, which has $864 billion in ETFs globally, studied the behavior of the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) from May 1 to July 5 to see how one part of the market fared and test that thesis for clients. Matthew Tucker, head of the iShares fixed-Income strategy team at BlackRock, says the secondary market in ETFs provides a way for sellers to find buyers without having to transact in the underlying bonds. This is in direct contrast to traditional mutual funds, whose managers have to sell underlying bonds to meet redemption requests from investors.
As part of its analysis, BlackRock looked at what happened on the five most active trading days in the fixed-income markets in May and June. The firm found that the HYG ETF — which had never traded more than $1 billion in shares in a day — breached that level on each of the five days as investors reacted to the Fed news. “That is an indicator that when we have these distressed markets, we see investors turn to ETFs as a way to position portfolios and respond to new market information,” says Tucker.
Investors redeemed HYG shares during this period — $180 million on May 29 alone. But that was offset by the $1.03 billion that changed hands in total that day. As a result, $849 million — the difference between redemptions and overall activity — of high-yield trades crossed on an exchange that did not require anybody to trade a high-yield bond, says Tucker.
According to the Financial Industry Regulatory Authority’s Trade Reporting and Compliance Engine (TRACE), approximately $6 billion of high-yield bonds trade on any given day. This volume remained relatively stable during the highly volatile months of May and June 2013. The roughly $1 billion in HYG shares that traded daily during this time period provided new liquidity to the markets. “The amount of increased liquidity that ETFs like HYG provided was meaningful,” Tucker notes.
In response to liquidity concerns, investors are often picking individual bonds for their portfolios and adding ETFs to get broader exposure. The ETF market is much more efficient than the underlying bond markets. For instance, during the roughly two-month period that BlackRock analyzed, the spread — the difference between the bid and the ask price — for HYG shares was 1 to 2 basis points. That’s a tiny fraction of the typical spreads for high-yield issues, which fall between 50 and 100 basis points.
“ETFs proved their worth as a viable hedging product,” says Robert Smith, president and chief investment officer of Austin, Texas–based Sage Advisory Services, which has $10 billion in assets under management. He adds that some investors have criticized ETFs for bringing more price swings to the market because they can be easily bought and sold. But Smith does not fully accept this argument. “You could argue they brought volatility, but the market was going to be volatile anyway,” he says. “It mitigated what could have been violent volatility because the cash markets would not have been able to carry the load.”
Smith says many of the ETFs in the core-plus area of the fixed-income markets — the SPDR Barclays High Yield Bond ETF, the iShares iBoxx $ Investment Grade Corporate Bond ETF and the iShares S&P U.S. Preferred Stock Index Fund ETF— were volatile because they offered investors exactly what their sponsors promised: mobility. “It’s easy in and easy out,” he says. “You really have to look at the technology of ETFs and ask whether it provided some support for the desires of the market. I say yes, it did.”
Smith, who calls the spreads seen in the underlying markets in mid-2013 “a joke,” does not believe that ETFs added volatility to the market. “They were just reflective of emotions at the time,” he explains. But although Smith agrees with many analysts that ETFs mitigated some of the pain in the marketplace, in his view bond trading faces pressing long-term and complex problems that are hardly a laughing matter.
