Central banks took an enormous leap on the street to direct market intervention in 2020. All developed market central banks added direct purchases of company bonds to their quantitative easing (QE) packages. As of 31 December 2020, the European Central Financial institution (ECB) and the US Federal Reserve held €250 billion and €46 billion in company bonds on their respective steadiness sheets.
Though these holdings aren’t as huge as whole authorities debt, the way in which the Fed performed this financial coverage intervention was somewhat novel. It purchased shut to six% of the overall belongings underneath administration (AUM) in US company bond exchange-traded funds (ETFs) and outsourced the execution to BlackRock.
It was simply the newest illustration of how buy-side credit score market contributors have developed for the reason that international monetary disaster (GFC). Over the past decade or so, the buy-side construction has grown extremely concentrated, a lot in order that immediately the world’s high 5 asset administration corporations command greater than 27% of worldwide credit score AUM.
On the similar time, efforts by regulators to discourage extreme risk-taking by monetary intermediaries has restricted the latter’s capability to offer market liquidity. Concurrently, low rates of interest and central financial institution bond shopping for have inflated company bond issuance, making the necessity for liquidity services extra vital than ever.
In consequence, many market contributors have turned to ETFs. Why? As a result of they imagine that — as intra-day traded devices invested in lots of index-tracking securities — ETFs can present another supply of liquidity.
Such considering is flawed. Funding in these securities has considerably elevated ETFs’ prominence available in the market and established a brand new kind of huge and vital buy-side investor within the type of the ETF sponsor. However this investor might not have the identical funding targets or incentives as its conventional buy-side counterparts
Company Bond Market Purchase-Aspect Construction
For a few years, credit score markets have been notoriously uncovered to issuer focus danger. The Monetary sector in funding grade (IG) and the Power sector in excessive yield (HY) signify 15% and greater than 20%, respectively, of the danger of every of those markets globally.
However whereas the issuer perspective is vital for assessing danger, traders also needs to take into account the buy-side of the market.
The worldwide bond market’s present buy-side construction is difficult to explain objectively. Bonds are generally straight held by non-financial entities or by liability-driven traders that don’t all the time report all their holdings publicly. For example, information from the Fed’s Circulation of Funds present that funding funds whole near 30% of the company and international fixed-income belongings held by US entities. Insurance coverage corporations are the most important homeowners of those belongings with a 37.5% share of the overall as of 31 December 2020.
This helps clarify why the consequences of buy-side focus and the results for the company bond market construction have up to now been largely ignored.
To evaluate these traits, we used Bloomberg information to construct an aggregated view of all of the funding corporations advising or straight holding securities included within the ICE-BofA International Company and HY indices. This universe of two,847 funding administration corporations covers 33% of the overall international IG and 41% of the worldwide HY indices. Our evaluation confirmed a cloth focus on the investor aspect: 45% of IG and 50% of HY markets are held by the highest 10 funding corporations.
What explains this heightened focus? The mutual fund universe provides some perception. Mutual funds are essentially the most actively traded buy-side entities and given their higher availability, they permit for extra in-depth evaluation. However company bonds are eligible investments for a lot of different fixed-income methods, so the universe past company bond-focused mutual funds should be taken under consideration. For the sake of completeness, we’ve additionally included so-called “Combination” methods in our evaluation, together with company bond-focused ones.
The chart under highlights the extent of buy-side focus: The highest three asset administration corporations signify 28% of AUM, whereas 90% of company bond ETF belongings are managed by solely three corporations.
AUM Focus amongst Administration Firms by Fund Kind
Statistics aggregated from 7,606 fixed-income mutual funds targeted on fixed-income “Combination” or “Company” bonds methods in exhausting currencies (CAD, CHF, EUR, GBP, JPY, and USD) with greater than $50 million AUM. Complete AUM for this mutual fund group amounted to $5.4 trillion as of 31 December 2020. The chart above offers two completely different splits of this similar universe: 1. ETFs (principally passive methods as energetic ETFs are a really minor a part of the universe) vs. energetic. 2. Company IG- vs. company HY-focused mutual funds.
Passive Investing’s Position in Bond Markets
No matter one’s perspective on passive investing or the ETF as an funding car, this market is presently working in an oligopolistic construction with potential impacts on value formation, liquidity, and the energetic administration trade as a complete.
Whereas the ETF sector’s share of whole mutual fund trade AUM began to rise earlier than the GFC, it accelerated considerably within the aftermath of the disaster. Although ETFs quantity to 9% of the general funds in our evaluation (together with the so-called combination methods), greater than 25% of company IG-focused mutual funds are invested by way of ETFs, as are barely greater than 12% of HY-focused funds.
Share of Passive Funds (ETFs) in Mounted-Earnings Mutual Fund Universes by Technique
Statistics aggregated from 7,606 fixed-income mutual funds targeted on fixed-income “Combination” or “Company” bonds methods in exhausting currencies (CAD, CHF, EUR, GBP, JPY, and USD) with greater than $50m AUM. Complete AUM for this mutual fund group amounted to $5.4 trillion as of 31 December 2020.
The rise of ETF investing within the company bond market is essentially pushed by the ETF’s skill to effectively replicate broad indices in addition to its exchange-traded function. The latter high quality alleviates problems with value transparency and makes the safety accessible to a broad set of traders.
For the reason that GFC and the next regulatory restrictions positioned on monetary establishments, ETFs have develop into the primary liquid devices obtainable to varied traders for managing credit score publicity. The ETF’s share of flows into or out of the asset class are much more spectacular: ETFs accounted for nearly 50% of inflows into IG company funds and 30% into HY during the last three to 5 years.
ETF Share of USD Mounted-Earnings Fund Inflows
Statistics aggregated from 7,606 fixed-income funds targeted on fixed-income “Combination” or “Company” bonds methods in exhausting currencies (CAD, CHF, EUR, GBP, JPY, and USD) with greater than $50 million AUM. Complete AUM for this fund group amounted to $5.4 trillion as of 31 December 2020. Flows are computed on a month-to-month foundation first and ETF circulation shares on a quarterly foundation.
The Fed’s choice to incorporate these devices in its pandemic-related QE packages acknowledges this actuality: The liquidity of company bonds relies on ETF buying and selling circumstances.
But evaluation of the US ETF fairness and fixed-income universes reveals this premise shouldn’t be wholly correct. Excluding essentially the most liquid decile of Treasuries funds, fixed-income ETFs seem two- to five-times much less liquid than their fairness counterparts. This helps additional clarify the necessity for the Fed’s intervention within the company bond market in 2020.
Most Low cost to NAV for US-Listed ETFs, Common by Deciles, December 2019 to December 2020
Universe of energetic fairness and fixed-income ETFs with AUM above $1 billion as of 31 December 2020
Excessive market environments, reminiscent of that of the March 2020 disaster, remind us that whereas ETFs are exchange-traded devices, that alone doesn’t assure that the underlying securities are resistant to liquidity stress. On the contrary: The excessive focus amongst ETF suppliers — amongst ETF replication algorithms — tends to additionally focus buying and selling strain on particular bonds. These commerce extra typically and incur extra volatility in addition to greater price of liquidity when ETFs come underneath promoting strain.
In fact, ETF automobiles aren’t with out prices for traders. Essentially the most missed amongst these are these associated to ETF bonds’ normal premium together with the issuer danger concentrations inherent in underlying debt-weighted company bond indices. For these causes, company bond ETFs don’t acquire the complete market danger premium over the long term.
Given this context, the oligopolistic market construction that has shaped as a result of affect of ETFs must be acknowledged.
Within the second a part of our evaluation, we are going to lay out the implications this has for traders searching for to generate alpha from fixed-income markets and thus for portfolio development itself.
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All posts are the opinion of the writer. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially replicate the views of CFA Institute or the writer’s employer.
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