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Bond ETFs: Low cost, liquid and effective


ume of $2.1bn (£1.6bn) and trades at 1bps wide.¹


Armit Bhambra Head of iShares UK Retirement, BlackRock


Fixed income will continue to play a pivotal and multi-faceted role in European pension scheme portfolios. Whether it be for growth, income or liability and cash-flow matching, many schemes in the region will need to hold bonds as they de-risk in a low yield environment.


The regulatory changes and increased capi- tal requirements that resulted from the global financial crisis have reduced invest- ment banks’ willingness to hold bond inventory, therefore impacting market liquidity.


In areas such as high yield and emerging market debt, bond ETFs allow access to the asset class at a fraction of the cost of invest- ing in the underlying bonds.


This article explores why schemes should add bond ETFs to their toolkit.


SOURCES OF ETF LIQUIDITY There is one feature of ETFs that is unique and not shared by mutual funds: they have a secondary market, whose benefit is accen- tuated when the underlying market is costly to trade. For example, the round-trip cost of trading cash bonds in the US high yield market can be around 75bps. However, the iShares iBoxx USD High Yield Corp Bond ETF (HYG) has an average daily vol-


In the past, it was a common belief that Europe-domiciled ETFs lacked the liquidity required to facilitate trades of institutional scale. But the volume of large trades in these markets continues to grow. This is because liquidity between US-domiciled ETFs and Europe-domiciled (UCITS) equiv- alents is fungible. In other words, clients can consider the combined liquidity of US and UCITS bond ETFs that track the same index. For example, a client looking to trade a UCITS ETF can benefit from the secondary market liquidity of the US-domiciled ETF if the authorised participants facilitating the trade use the same underlying bonds in each fund’s creation units. This is common practice across several iShares ETFs that track markets such as US investment-grade credit, hard currency emerging market debt and US dollar floating-rate bonds. What has all of this meant for bond ETF usage by pension schemes? Meaningfully lower transaction costs have resulted in a plethora of applications that have helped solve the challenges pension schemes face. Initially, we saw schemes use ETFs for interim beta when, for example, switching between managers and tactical asset alloca- tion. However, some schemes have become more sophisticated, using bond ETFs as a replacement for credit derivatives, building custom liquidity sleeves and, for some exposures, strategic asset allocation.


FOUR KEY TRENDS TO DRIVE BOND ETF MARKET GROWTH


Over the past 10 years, the global bond ETF market has reached a record high five times


16 | portfolio institutional | December-January 2020 | issue 89


and assets now stand at more than $1trn (£774.3bn). However, bond ETFs still com- prise only 1% of total cash bonds outstanding.² At BlackRock, we believe that global bond ETF assets are well positioned to double to $2trn (£1.5trn) by the end of 2024, for four reasons:³


An evolution in portfolio construction: Bond ETF investors are hardly passive. Mil- lions of people are actively using them in innovative ways to achieve a variety of outcomes. Modernisation of the bond market: Bond trading as a percentage of debt outstanding has declined in the post-crisis, dealer-cen- tric world and market participants look to ETFs and electronic trading to help improve liquidity.


ETF innovation: The development of new bond ETF exposures will add convenience for investors, provide new tools to custom- ise portfolios and drive future bond ETF adoption. More bond ETFs will incorporate environmental, social and governance (ESG) inputs into their methodologies or target green bonds to fund sustainable projects.


ETF adoption by institutional investors: Institutions other than pension funds are increasingly using bond ETFs. Insurers are deploying short-term government bond ETFs to manage their cash reserves; fund managers hold bond ETFs instead of cash in anticipation of new issues; and endow- ments use bond ETFs while transitioning between non-liquid strategies and active managers. So what does this mean for the bond ETF market? We will likely see a deepening of the same dynamics we have seen play out


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