An impact that stretches far beyond their 1% market share
The rise of exchange-traded funds from niche product into a dominant market vehicle has upended Wall Street, accelerating the move into passive investing and leading a drop in fund fees, a shift that shows no sign of stopping. But nowhere has their impact been felt more acutely than in the fixed-income market.
“Quite simply, ETFs have modernized fixed-income markets,” wrote Matthew Tucker, head of iShares Americas fixed-income strategy.
The BlackRock’s BLK, +0.87% iShares suite of funds makes it the biggest player in the ETF segment, maintaining a market share of 37%, according to research firm ETFGI. It sponsors the two largest bond funds—the iShares Core U.S. Aggregate Bond ETF AGG, +0.02% and the iShares iBoxx $ Investment Grade Corporate Bond ETF LQD, -0.05% —as well as the iShares iBoxx $ High Yield Corporate Bond ETF HYG, +0.03% the most widely used ETF for “junk” bonds.
It has been 15 years since the first bond ETF was released, and according to Lee Kranefuss, a founder of iShares who is currently the co-chairman at 55 Capital Partners, they were what first led to the explosion in ETF usage. While the first ETF—the SPDR S&P 500 ETF Trust SPY, +0.01% —has traded since 1993, it was the 2001 Enron scandal that demonstrated their value. Enron’s bonds had been AAA-rated, and after their collapse, the iShares investment-grade bond ETF was seen as a cheap way to get diverse access to a lot of highly rated bonds without having to select them individually.
“They enable investors to efficiently access fixed-income markets on demand. With a single ticker, an investor can tap into thousands of bonds in a specific sector without having to hunt for inventory or navigate multiple offers from multiple brokers.”
Now, the utility of bond ETFs has expanded.
Tucker listed three ways that ETFs have changed the bond-market landscape, including increased access to fixed-income securities. Compared with equities, bonds are typically less liquid and pricing is more opaque. They’re also traded over the counter, making them more difficult for retail investors to trade.
“Bond ETFs have democratized access to this marketplace. An individual investor in Kansas can trade bond ETFs on a stock exchange in the same way as a hedge fund manager in New York would,” Tucker wrote in a recent report marking the 15-year anniversary. The previous state of the bond market favored larger and more sophisticated investors, he added, but bond ETFs helped “level the playing field.”
He added, “They enable investors to efficiently access fixed income markets on demand. With a single ticker, an investor can tap into thousands of bonds in a specific sector without having to hunt for inventory or navigate multiple offers from multiple brokers.”
Tucker’s views were echoed by other investors, who highlighted the way the vehicle has eased access to parts of the universe that were previously the near-exclusive domain of more elite market participants.
“There’s no question that ETFs have made fixed-income investing, which had previously been the purview of a more selective group of investors, into a more general option. ETFs brought the bond market to the retail investor, making things available that weren’t before, which is a great thing from our point of view, especially in regards to our smaller clients,” said Chris Bertelsen, chief investment officer at Aviance Capital Management, which has $2.3 billion in assets and exclusively invests in bonds through ETFs.
“It used to be that an advisor would buy three or four bonds for a client, and would maybe be taking on risk. Buying an ETF reduces that risk through diversification, by holding a lot of different bonds rather than just a few. It has made things like high-yield a very valid strategy.”
Fixed-income ETFs remain a relatively small part of both the bond market and the ETF market, but they are a growing category in both. Bond ETFs have $547.6 billion in assets, according to FactSet data, and they have seen inflows of $83.4 billion thus far this year. To compare, equity products have $2.44 trillion in assets, including $190.7 billion in year-to-date inflows.
At current levels, according to data cited by Tucker, bond ETFs are less than 1% of the global bond market.
Improved liquidity was the second factor he said ETFs had brought to the bond universe, as ETFs—as the name implies—are traded on exchanges, as opposed to over the counter. “Exchange trading creates liquidity and allows for bond ETFs to be used to manage risk and adjust market exposure,” he wrote, adding that the iShares funds for investment-grade and high-yield corporate bonds both traded thousands of times a day, whereas even their most liquid individual components only traded a handful of times.
“Having more ways for investors to access categories like high-yield or investment-grade corporate bonds does create liquidity in those markets, and the move into them has been meaningful,” said Rui De Figueiredo, chief investment officer and co-head of the Solutions/Multi-Asset Group at Morgan Stanley Investment Management. “It is challenging to replicate those indexes and benchmarks on your own, and these ETFs tend to be the most liquid ways to access them.”
Finally, Tucker credited ETFs with allowing bond investors to “express views with precision,” saying they could be used “to build model portfolios, follow asset allocation guidance, or express their own tactical views, all in a low-cost manner.” Fixed-income ETFs have an average fee of 0.2%, according to the Investment Company Institute. In 1996, bond mutual funds charged an average of 0.85% of assets.
“LQD offered something much cheaper and simpler (than owning individual bonds),” Kranefuss told MarketWatch earlier this year, referring to the ticker symbol for the investment-grade ETF. “I like to say that the hardest trade someone has with an ETF is their first trade.”