Bond ETFs Poised for Growth

Shanny Basar

Interest in bond exchange-traded funds is set to increase due to the influx of new types of users and global demand for Ucits ETFs.

Antoine Lesné, head of SPDR ETF research and strategy EMEA at State Street Global Advisers, said at the Bloomberg Invest ETF conference in London yesterday that in 2004 and 2005 there were a only few ETFs on government bonds. However, there has since been an expansion into corporate bonds, high-yield and emerging markets.

“Quantitative easing increased demand for bond ETFs,” added Lesné. “Demand will continue as regulation has made it more difficult to trade the underlying corporate bonds and products have been developed that give active managers the exposures they want.”

Bond ETFs attracted $91.9bn (€78.4bn) in net inflows last year, an increase of 50% from 2015 according to fund data provider Morningstar. In Europe in the first eight months of this year fixed income ETFs and ETPs had net inflows of $22.1bn, which is less than the $25.6bn in same period last year, according to ETFGI, an independent research and consultancy firm on trends in the global ETF/ETP ecosystem.

Manav Gupta, co-head, European credit flow trading business at Goldman Sachs, said at the conference that more credit specialists have become involved in trading ETFs as they have become another tool they can use to manage exposures.

“About 10% of overall corporate bond trading volumes comes from ETFs,” added Gupta. “ETFs are an important source of liquidity in the bond market and will grow further.”

Simon McGhee, head of ETF advisory at ETF market maker Bluefin Europe, said at the conference that users of bond ETFs have expanded from private banks and multi-asset managers to credit funds and insurers, as the latter want to take bonds off their balance sheet. McGhee continued that hedge funds are also using bond ETFs as an alternative to derivatives as they are more liquid and enable trades in bigger sizes.

He added the market is also being driven by global demand for UCITs ETFs, outside the US. The European Union’s Ucits Directive covers retail asset management products.

“There is a huge amount of wealth creation in Asia and the middle class is printing money,” said McGhee. “We follow wealth, like luxury goods manufacturers, and Asian wealth managers want Ucits ETFs.”

He continued that Bluefin had transacted its first trade from Latin America for a Ucits ETF two weeks ago.

There have been concerns that bond ETFs may become illiquid as interest rates rise or volatility increases. However, McGhee argued that the market was tested when President Trump won the US election last year and there was a move to sell risk assets, such as investors selling emerging market bond ETFs from iShares and SPDR without market disruption.

“To sell out of the of the underlying bonds, if you could sell, cost 300 to 400 basis points below previous day’s price,” McGhee said. “We won an $88m ETF block trade in competition and got out at 82 basis points.”

Regulators have been focussing on ETFs as they have grown in size and in May the Central Bank of Ireland  published a discussion paper on ETFs as part of its role in maintaining stability and protecting consumers.

Gerry Cross, director of policy and risk at the Central Bank of Ireland, said in a statement: “ETFs are the most important product development the investment funds industry has seen in the last 20 years – this is evident from their exponential growth. This discussion paper sets out the results of substantial research conducted within the Central Bank of Ireland on the growth of ETFs.”

In a response to the paper, the International Capital Market Association said the central bank should focus on possible flaws in the structure of exchanges rather than risks which have been suggested as inherent in the design of ETFs.

“We do not consider that there are risks unique to an ETF which are not already addressed by the Ucits and MiFID frameworks,” added ICMA. “Most of the public and regulatory concern about ETFs, such as the alleged “liquidity illusion”, stem from a lack of understanding about the peculiar characteristics of ETFs, as opposed to traditional open-ended funds.”

ICMA continued there is also an insufficient focus on some of the short-comings of the market micro-structure around ETFs which can affect the pricing of underlying securities in volatile trading conditions, and have a knock-on effect on the liquidity of an ETF’s secondary market. For example, abnormal trading sessions, market closures and use of circuit-breakers have in some instances forced exchanges to temporarily suspend trading for certain ETFs. However in other instances, ETFs acted as a price discovery tool even when exchanges had halted trading in underlying securities.

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