When Leighton Shantz, director of fixed income for the Employees Retirement System of Texas (ERS), wanted to get out of a $1.4 billion position in investment-grade corporate bonds two years ago, he didn’t tell his traders to start calling Wall Street to sell individual securities. “Even in 2013, we were worried about Street liquidity,” he says.
Instead, Shantz used fixed-income exchange-traded funds, baskets of individual bonds, to reposition $26 billion ERS’s bond portfolio. After negotiating with ETF sponsors over which of its fixed-income holdings would fit the profile of their ETFs, the pension plan delivered securities to an authorized participant — a designated market maker for a specific ETF — which completed the transaction. In return, the pension plan received two ETFs that Shantz later sold. “[Using ETFs] was a more efficient way of working our way out of those bonds,” he says.
This unusual transaction — creating a basket of securities that can be exchanged for an ETF — is one way that institutional investors are using exchange-traded products to get around liquidity problems in fixed-income markets.
Few bonds trade on exchanges, but that hasn’t stopped investors from availing themselves of some of the benefits of the equity markets for their fixed-income portfolios. As big players find it increasingly difficult to buy and sell individual securities in the bond markets, they’ve been turning to ETFs as an alternative.
Using ETFs, bond managers are exploiting the advantages of centralized and continuous trading, including price transparency, even though underlying fixed-income markets remain largely untouched by exchange technology. ETFs now play a huge role for investors as banks continue to step back from their historical role as principal market makers in the bond world.
Since 2008 daily trading volume in U.S. bond ETFs has grown about 700 percent; it now averages $3.5 billion per day, according to Bloomberg and asset manager BlackRock. The exchanges have become another place to trade fixed-income instruments. Investors have also poured more money into bond ETFs every time there’s a stress in the bond markets, including in 2013, when the U.S. Federal Reserve Board said it would start reining in quantitative easing, during the U.S. Treasury downgrade two years earlier and amid the 2008–’09 financial crisis.
Although ETFs aren’t an equal swap for specific bonds or loans, many investors are finding that they’re good enough. For instance, a mutual fund manager might use a large high-yield bond ETF like the one offered by State Street Global Advisors (SSgA) to gain immediate exposure to the sector. Over time the manager can replace some of the ETF position as individual securities become available at fair prices. Managers are also holding bond ETFs as one more source of assets, like government bonds, that they think can be fairly easily sold on an exchange if markets turn down.
“ETFs offer a pathway for trading that doesn’t exist through the traditional OTC market, allowing buyers and sellers to meet directly without anyone’s balance sheet being involved,” says Mark Wiedman, New York–based global head of BlackRock’s iShares ETF business. “That is a big transformation. The basket starts to trade just like Apple.”
In fact, 4 of every 5 fixed-income trades at BlackRock occur through that pathway, Wiedman explains, not through the primary creation and redemption mechanism. In August, when investors were exiting high-yield bonds en masse, BlackRock’s high-yield ETF shrank by $655 million. But there was also about $700 million in daily secondary trading, with volumes ranging from roughly $300 million to $1.6 billion. “That secondary trading is new liquidity,” Wiedman emphasizes.
Trading of high-yield bonds has traditionally taken place almost exclusively through dealers, but now 10 to 15 percent occurs via ETFs. Investors are also using bond ETFs as a pricing source. The baskets of bonds trade all day — and thus are priced all day. Although an ETF’s price represents a basket of securities, it can provide an indicator of the value of underlying bonds in a still-opaque market.
But there are other uses for bond ETFs — witness the Texas transaction — now emerging that could help mitigate some of the market’s liquidity problems. The ETF can be employed as a mechanism to send an investor’s individual bonds to a broker or to receive individual securities that an investor wants. Think of it as a box that can be opened and closed or a wrapper that can be zipped and unzipped. Authorized participants do this all the time when they create and redeem shares. Wiedman says investors are increasingly taking individual bonds they hold and bringing them to an authorized participant that wraps them in the ETF. That’s the zip. The investor then gets back one security, an ETF.
Unzipping involves investors who may want the underlying bonds that are wrapped in an ETF. They buy the fund and ask its authorized participant to unzip it and keep some or all of its constituent bonds. Zipping and unzipping aren’t quite so simple as these examples — an authorized participant might not want an investor’s exact basket of bonds — but investors are adopting the process. “It’s using equity market technology for fixed income,” Wiedman says.
David Mullen, New York–based fixed-income product manager at Bloomberg, says, “This is the next phase of ETFs, something that will help stem the illiquidity problem in the cash bond market.”
ERS has been an early mover in using ETFs as an alternative to Wall Street. Fixed-income director Shantz says that in 2013 the Austin-based pension plan was moving out of investment-grade corporate bonds because their potential returns were too low for the risks, and there wasn’t enough yield to offset the increased liquidity risk that they posed to the portfolio. The plan wanted to buy Treasuries as a liquidity anchor and high-yield bonds for the return-seeking part of its portfolio. The ETF transaction allowed the Texas system to sell quickly without moving the market.
Shantz, who has since done other such deals, adds that he’s surprised there aren’t more managers taking advantage of the capabilities. “When you look at the balance sheets of the Street post–Dodd-Frank, you sit there and say, ‘It will be 2008 all over again if investors flee credit,’” he says.
Seeing the opportunity, fund companies and others are implementing technology and various services to make unzipping easier and more straightforward. For one, institutional investors need to be able to describe fixed-income ETFs using the same terms they use for individual bonds, such as yield and spread. Bloomberg recently updated its YAS tool, which provides yield and spread analysis of bonds, to include ETFs when fund sponsors provide nightly underlying information about portfolio holdings.
The upgrade grew out of an effort initiated by Bloomberg, BlackRock, SSgA and Tradeweb Markets to standardize the methodology for calculating metrics on ETFs such as yield, spread and duration. With that knowledge, which became available for 200 ETFs in October, investors can get a more up-to-the-minute picture of a fund’s potential return and make more informed decisions about whether to buy or sell or if they want access to its underlying bond holdings.
So far, in addition to offerings from BlackRock and SSgA, ETFs from Charles Schwab & Co., Guggenheim Investments, Invesco and Pacific Investment Management Co. can be analyzed on YAS. The group plans to begin addressing standards for other fixed-income ETFs, such as inflation-linked and mortgage-backed securities, in the coming weeks.
“Now investors can look at ETFs as if they were one big bond,” Bloomberg’s Mullen says. “They can compare ETFs with other fixed-income products, like cash bonds, CDX indexes and total return swaps to see which will fit into their portfolio and which will provide them with more liquidity.” Like institutions, traders also wanted to be able to talk about ETFs in traditional fixed-income language.
A year ago, to streamline fixed-income ETFs’ creation and redemption, Bloomberg and SSgA joined forces to introduce a service called BSKT, for the fixed-income ETF primary market. BSKT helps ETF sponsors, authorized participants and market makers to assemble and negotiate baskets.
Still, the process isn’t as easy as calling a dealer and selling a $10 million block of bonds. Investors must evaluate the different bonds in their portfolios that need to be swapped in and out to achieve a certain result, and optimize that with the specific securities that fund sponsors need in their ETFs to best track their indexes.
If it’s a fit, the investor delivers the bonds to the authorized participant, receives the ETF back and sells it to complete the transaction. Alternatively, if investors are repositioning their bond portfolios and can’t find the securities through a dealer, they can look for them in an ETF and do things in reverse.
Mullen sees the creation and redemption mechanism, or zip and unzip, as a possible solution to the bond market liquidity problem and as an alternative to all-to-all trading platforms, which allow investors and other market participants to connect with one another and trade. Both options will require big shifts in how asset managers and dealers do business. There are barriers to more efficient zips, too: For example, authorized participants would still collect a fee for transactions, but they would lose the spread they now make when they buy underlying securities.
There’s no shortage of critics of bond ETFs, and problems this past summer pricing securities within equity ETFs will add controversy and uncertainty. These vehicles are bringing incremental liquidity and innovation to the bond markets, though. In 2013, for example, when the Fed signaled to the market for the first time since the financial crisis that it would be tapering its bond purchases, volatility soared as investors started redeeming their bond funds. But the secondary market in ETFs provided meaningful additional liquidity, so sellers of those bond baskets could find buyers on the equity exchanges without having to use the primary markets.
That meant buyers and sellers were meeting on the exchange, rather than knocking on the door of a heavily regulated bank to put up capital and make the trade. That’s a clear advantage over traditional mutual funds — still holders of the majority of securities like high-yield paper — which require portfolio managers to sell stocks and bonds to meet redemptions.
Mullen says critics aren’t differentiating between the largest and most liquid ETFs, for which there is about eight to ten times more volume trading on the exchange every day than trading through creations and redemptions, and smaller ETFs, which lack such strong interest from investors and could pose problems. “You can’t paint the entire industry with the same broad brush,” he contends.
He also points out that it won’t be a surprise to investors when rates go up and bond prices fall. “Investors might reposition their portfolios, but they’re unlikely to completely sell out of fixed income,” he says.
Says ERS’s Shantz: “I think ETFs have done a lot. They’ve absorbed a lot of the Street’s disappearing market-making capacity.”
