Fixed-Income ETFs: A Rising Tide?

Given the volatility of equity markets, many investors are on the lookout for new fixed-income opportunities. As such, fixed-income exchange-traded funds (ETFs) have grown in popularity as investors have increasingly added them to their portfolios.

For insight on the expanding use of these vehicles, among other trends, we recently spoke with Bill Ahmuty, who is managing director and head of the SPDR Fixed Income Group at State Street Global Advisors, to get his perspective.

What follows is a lightly edited transcript of our discussion.

CFA Institute: What is the relative size of the fixed-income exchange-traded fund market and what have been its growth drivers?

Bill Ahmuty: The US fixed-income ETF market is $672 billion in AUM (per Bloomberg as of January 8, 2019). In 2018, we saw $97 billion of inflows, but total fixed-income ETF AUM only increased by $79 billion, as lower price movements in credit products eroded some of the AUM. Fixed-income ETFs are still a relatively small part of the overall fixed-income market – just over 1% of the US fixed-income market – and when we look at certain asset classes where fixed-income ETFs are focused, say high yield, ETFs are still roughly only 4% of the overall high-yield market.

Fixed-income ETFs were first launched in the early 2000s but didn’t gain a great deal of traction until post-Great Financial Crisis (GFC). Price transparency, holdings transparency, and ease of execution were some of the main drivers of the growth and ETF liquidity post GFC, particularly as many dealers reduced their balance sheets and transitioned from principal- to agency-based trading models in cash bonds.

Who are the buyers of these instruments?

ETFs are used by institutional buyers as well as what we call intermediary buyers. While the data doesn’t allow for pinpoint accuracy, the breakdown of fixed-income ETF ownership is skewed slightly in favor of the intermediary (and direct retail) segment.

In the institutional space, buyers are asset managers, hedge funds, insurance companies, pensions, and sovereign wealth funds. Insurance companies have increased their investments to fixed-income ETFs, and according to an October 2018 study, 61% of insurance companies expect to increase their use of ETFs over the next three years. Recent statutory accounting guidance by the National Association of Insurance Commissioners (NAIC) may also create more demand for fixed-income ETFs with insurance companies.

How are fixed-income ETFs typically used in client portfolios?

Institutional users have adopted fixed-income ETFs for a number of reasons:

1. To gain beta exposure to certain areas of the market where they previously did not have tools to access.
2. As an efficient tool to modify your exposures and manage risks, such as duration and credit risk.
3. More and more, we are seeing asset manager clients using fixed-income ETFs to manage their cash needs – as a tool to quickly gain exposure when they have excess cash or to sell the ETF when their funds are seeing redemptions.

Can you provide some examples of how clients are managing their cash needs with fixed-income ETFs?

Some of the more innovative uses of fixed-income ETFs are based on the concept that due to the in-kind creation and redemption process, the fixed-income ETF is a fungible instrument with cash bonds. End-investors have become more innovative in using them as tools for managing inventories and positions, not just as tools for exposures. I’ll give two examples:

1. The first is an asset owner that may have 2,000 line items in their portfolio and managing these positions in-house. Most likely, their alpha is generated only from a small subset of their overall portfolio. The ETF can be a great tool to help consolidate positions. Implementing such a strategy can be executed by selling bonds in the market and simultaneously buying an ETF, or the more cost-effective method would be to work through an authorized participant (AP) to exchange the bonds for shares of an ETF, a concept we refer to as transfer of assets.
2. Another example is an asset manager that just had an influx of cash while markets are very volatile. Buying the ETF market will allow the manager to have immediate exposure to that asset class. Once the decision is made on more granular exposure, investors working through an AP can redeem out of the ETF and take delivery of the individual bonds through the redemption process.

What are ownership cost considerations for fixed-income ETFs?

Total expense ratio (TER) is always the headline number, but it is imperative to consider cost of execution when evaluating the overall cost of ownership. Execution costs include not only the bid-ask spread, but investors should also be aware of the premium or discount of any ETF, as well as the volatility of that premium or discount. Securities lending may also provide end-investors with a way to reduce their holding costs of a specific ETF.

This all sounds great. So what are some of the reasons why investors don’t include ETFs in their portfolios?

I think there’s still a lot of education that’s needed, not just in educating investors about the use cases for fixed-income ETFs, but when it comes to institutional fixed-income users, there is a need to help translate some of the equity concepts of an ETF into more familiar fixed-income terminology.

We essentially need to “bond-ify” fixed-income ETFs, which has become a bit of an industry project over the past few years. One example of this is the Yield and Spread Analysis (YAS) screen on Bloomberg. This is a traditional screen for evaluating risk metrics of individual bonds that has now been adapted to analyze fixed-income ETFs in similar terms. Most bond investors don’t care if you tell them the price of an ETF is $37.12 – that means very little to them. They want to understand the duration, the yield, and the spread of the fixed-income product.

The Bloomberg YAS screen provides that type of information so that true bond investors can see and think about fixed-income ETFs as fixed-income instruments rather than equity instruments.

How has the sell side adapted to the growing fixed-income ETF market ?

Historically, fixed-income ETFs have been part of the equity division, and joint ventures were formed between fixed-income and equity divisions that looked great on paper but may not have been that effective in practice. Over the past several years, we’ve seen fixed-income ETF trading transition to become part of the fixed-income trading floors at broker-dealers. This change has been significant, as it allows for greater expertise within the underlying asset class and allows traders to leverage not just the inventory of the broader team but also other fixed-income beta products. In fact, we have also seen ETFs become a tool for balance sheet management for the APs and the dealers.

How active have hedge funds become in their use of fixed-income ETFs?

Hedge funds tend to gravitate toward the highly liquid products that have become active trading vehicles, as their time horizons are typically shorter in nature. In the fixed-income space, hedge funds tend to be more focused in high yield, investment grade, and emerging markets.

Talk to me about your index versus non-index portfolios.

State Street Global Advisors manages $378 billion in fixed-income beta assets (as of September 30, 2018). There is over $62 billion in AUM (as of September 30, 2018) within our SPDR fixed-income ETF lineup – the majority of which is managed as index strategies. Of that $62 billion, approximately $6 billion is actively managed by internal PM teams, as well as external subadvisers with proven track records in certain fixed-income asset classes.

Can you describe the liquidity of underlying instruments versus ETFs?

ETFs provide access to areas where it might be too expensive to go out and buy an individual bond, whether it’s municipals, high yield, emerging markets, etc. – so that’s where an ETF is a great tool for investors. The questions about liquidity are frequent. The ETF in worst cases is only as liquid as its underlying assets, but what we’ve seen is that over time ETFs create trading volumes (secondary market liquidity), which becomes additive to the liquidity of the underlying market (primary market). We often examine this relationship between secondary market activity and primary market activity. Most often, the secondary market volume is a multiple of the primary market volume. For example, for every $1 of ETFs that trade on the market, maybe only 20 cents are created or redeemed. A lot of the risk transfer of the ETF happens on exchange or directly between buyers and sellers. Proof of concept with this is when you see spikes of volatility within the market, you see that relationship typically expand, i.e., the amount of activity on the secondary market increases more than primary market activity.

How do fixed-income ETFs manage tracking error?

For the SPDR fixed-income ETFs that are created to track an index, tracking is one of our top priorities in managing the funds.

Given our scale and track record in fixed-income beta, we have applied the same techniques in managing our ETFs as we use for our other fixed-income beta strategies. We deploy the same type of optimization techniques in tracking those different indices, and also leverage our scale. In addition, our fixed-income ETF portfolio managers also manage other institutional mandates, thus allowing our PMs to have full insight into market liquidity and trends within their segment of the market.

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