The fixed-income market is taking notice of exchange-traded funds. With banks’ bond inventory at historical lows, ETFs can provide a liquid and efficient alternative to cash-bond investing.

Traditional bond traders have begun to track ETF-specific bonds to try to anticipate supply or demand of the bonds needed to create or redeem ETFs. “Everyday a new client is asking about fixed-income ETFs,” Aaron Kehoe, head of fixed income ETF trading at Cantor Fitzgerald, told Markets Media.

“Clearly it’s one of the fastest-growing asset classes in ETFs, if not the fastest. As more and more institutions adopt and start to use them, it will only get bigger.”

Fixed income ETFs provide a way to gain intraday exposure to an asset class where liquidity is currently tightly constrained, according to David Krein, head of research at MarketAxess.

“You hear quite often about the liquidity restraints that occur in the cash products,” Krein told Markets Media. “ETFs are a great wrapper but are ultimately linked and quite possibly, limited by the liquidity in the cash market. The nature of ETFs as a wrapper for the fixed income space is fundamentally different from that for equities.”

Kehoe and Krein will speak on a panel on fixed income ETFs at Markets Media’s Fixed Income Trading & Investing Summit on May 5.

In equities, Krein explained, ETFs provide intraday trading capabilities “because the equities are continuously priced all day, whereas in fixed income, most bonds are not trading on a given day. So the ETF is actually a great way to gain that intraday exposure.”

The flip side is one can only trade the ETFs’ exposure. “As long as you’re willing to live with the constraints imposed by the ETF, whether that be the index that it tracks or the market that it’s in or how many bonds it holds, there’s net leverage but it’s constrained to that ETF exposure,” said Krein.

At Cantor, Kehoe manages “all things fixed-income ETFs globally for our desk and for Cantor in general, so that comes down to pricing, trading, helping bring to market in terms of advice for issuers who are looking for product structure,” he said. “I don’t know if they’re necessarily a solution for the current issues in the fixed-income space but they’re definitely something that are becoming part of that market and whereas people have not really noticed them five years ago, now they are definitely taking notice of them.”

Krein joined MarketAxess earlier this year from Nasdaq OMX Global Indexes, where he led research and development of index methodologies across asset classes, which were used as benchmarks for active and passive investment funds globally. Prior to this, he held a senior position in product development and analytics at S&P Dow Jones Indices.

The mechanics of the interaction between the cash markets and ETFs “are still largely a black box to most, if not nearly all market participants,” said Krein. “The customers that trade on our platform really sit within this black box. They are the authorized participants. The authorized participants trade heavily on our platform in order to facilitate, to create, and then the redemption process of ETFs.”

Authorized participants—mostly large buy-side institutions– are a rapidly growing presence in investment grade, emerging markets, especially high yield. “The demand for cash market trading by APs is significant,” Krein said.

The ETFs sponsor’s responsibility is to maintain the portfolio so that it reasonably tracks that index in some cost effective way. “You think about equities as being a continuous two way markets versus the OTC structure in credit which are periodic auctions,” Krein said. “The credit markets don’t have continuously priced securities. There are simply different mechanisms for buyers and sellers to engage.”

Featured image via Redindie/Dollar Photo Club