Cash-Market Illiquidity Stokes Demand for Bond ETFs

Terry Flanagan

A loss of liquidity in global fixed-income markets and a host of other challenges facing investors has set the stage for what could be significant increases in institutional use of bond ETFs, according to Greenwich Associates.

A study conducted by Greenwich Associates and sponsored by BlackRock, which included interviews with 128 U.S. institutional investors, found that bond ETFs are taking on an increasingly vital role in institutional portfolios as regulations have forced global bond dealers to reduce their inventories and market-making activities, sapping liquidity from the market. Meanwhile, historically low interest rates are forcing investors to search for yield, while simultaneously preparing for a long-expected pick-up in rates and volatility.

Over the past 12 months, institutions’ need for liquidity has been a primary driver of fixed-income ETF demand. More than half the institutions in the study that have experienced liquidity problems say these issues have had a direct impact on their investment processes.

While institutions of all types have struggled with reduced liquidity in bond markets, ETFs have not suffered the same fate. Since 2008, bond ETF liquidity has grown more than four and a half times or at an annual growth rate of 33%.

Those dynamics are boosting institutional demand for ETFs. “Overall, 59% of fixed-income ETF investors in the study reported they have increased their usage since 2011, with growing numbers of institutional investors turning to ETFs as a liquidity enhancement tool,” said Greenwich Associates consultant Andrew McCollum in a release.

Institutions also are turning to ETFs to more readily achieve fundamental investment goals. For the past several years, investors have been adjusting portfolios in response to historically low yields, the potential for a prolonged rising rate cycle and to better weather spikes in volatility.

“As institutions shorten duration, diversify portfolios and seek out sources of attractive return by shifting assets to specialized and niche investments, they have found ETFs to be highly flexible tools to address both long-term strategic and short-term tactical investment objectives,” McCollum said.

These trends seem poised to keep growth of ETF usage by institutions at robust levels in the years ahead. One-quarter of the institutions in the study—and 40% of the investment managers—plan to increase their use of bond ETFs in the coming 12 months.

This momentum is likely to continue as institutions revisit internal investment guidelines and limits that had previously capped investors’ use of ETFs. Given these factors, Greenwich Associates expects fixed-income ETF usage will continue to build as institutional investors meet the realities of a challenging fixed-income marketplace with new and broader allocations to this highly adaptable vehicle.

Featured image via Stephen VanHorn/Dollar Photo Club

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