Fixed Income ETFs

Liquidity in an illiquid world.

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126851_milan_and_rainThe past few years have seen significant growth in the range of choices the exchange-traded fund (ETF) market offers institutional investors. They can now select from a wide variety of equity, alternative-market and fixed income ETFs, which together offer more capacity than ever to align portfolios to strategy in an efficient and flexible way. Yet while all ETFs operate according to the same broad principles—investors buy and sell shares in an ETF in exactly the same way they do a listed stock—each asset class has its own unique characteristics.

This is particularly relevant to bear in mind when investing in fixed income ETFs.

To institutional investors, this asset class holds remarkable potential. For one thing, fixed income ETFs have some unique advantages over direct holding of either cash or bonds. Indeed, one way to look at these ETFs is as a route to “bondize” cash—that is, attain the return of fixed income holdings while maintaining a level of liquidity that in most market conditions approaches that of cash.

Another advantage of these products is that they allow Canadian investors easy and diversified access to other fixed income investments, such as global bonds, municipal bonds and high-yield bonds. And more generally, fixed income ETFs can provide a shorting mechanism to hedge against broader market exposure.

Yet the most significant benefit of fixed income ETFs lies in how they trade on the exchange. After all, unlike equity-based ETFs, the underlying holdings in fixed income funds do not trade on the open market; transactions in the fixed income market are over-the-counter (OTC). In the OTC market, pricing information is fragmented and different sellers offer different valuations; reliable execution data are scarce; and only a certain portion of the market trades on any single day.

Compare this with the way fixed income ETFs trade. In the primary market, ETF shares are created either by in-kind, where designated brokers (typically in Canada these broker/dealers are from the large banks) deliver bonds to the ETF provider in exchange for ETF shares, or cash-creation, where designated brokers deliver cash to the ETF provider in exchange for ETF shares.

In terms of volume, this primary ETF market is dwarfed by trading in the secondary market, often by a factor of five or more. Where bid/offer spreads in the underlying fixed income OTC markets might be very wide, trading in the secondary market helps keep costs low—all the more so as the particular underlying fixed income market becomes less liquid. For instance, for December 2009 the bid/offer spread in the iShares Barclays 1-3 Year US Treasury Bond Index Fund (SHY) was 1 basis point; in the underlying fixed income market, the estimated spread was 1.6 bps. By stark contrast, the spread for the iShares Barclays iBoxx $ Corporate High Yield Bond Index Fund (HYG) was 2 bps, while the estimated bid/offer spread in the underlying market was 150 bps.

One consequence of these cost efficiencies is that fixed income ETFs sometimes trade at a premium or a discount to their Net Asset Value (NAV). Like all ETFs, the price of fixed-income funds represents a true executable price and can be bid up during periods of strong demand, or bid down during periods of selling pressure. When this premium or discount creates arbitrage opportunities for market participants, prices tend to return to the norm. Even then, however, under most market conditions many fixed-income ETFs typically trade at a premium to NAV, particularly for U.S.-listed ETFs.

Why? Bonds underlying U.S. ETFs are always marked on the bid side for NAV calculations, while the ETF typically trades at some point between the underlying market’s bid/offer spread (sustained premiums in Canada tend to be much less common, since Canadian Bond ETFs are valued using mid prices). Generally speaking, the premium to the NAV can be interpreted as the “creation cost” of the ETF, or the true executable price of investing in diversified, flexible pools of fixed income.

For large investors, this price transparency is one of the advantages of fixed income ETFs.

So is price discovery.

A stark illustration occurred during the credit crisis of September 2008, when fixed income ETFs offered huge benefits to market participants. At the time, credit markets were frozen, but credit ETFs continued to trade throughout the crisis. Even as the underlying market had become highly illiquid, fixed income ETFs provided price discovery that reflected the level of market risk and investor sentiment. True, the funds were trading at a significant discount. But they were trading.

In many cases, institutional investors find it cost-effective to participate in the fixed-income market through pooled or segregated funds. Yet some pension funds are opting to keep a small percentage of their fixed income assets in the ETF alongside the pooled fund.

For example, an investor with a 15% allocation in US credit might hold 95% of that in a very low cost index pool product and 5% in the iShares iBoxx Investment Grade Corporate Bond Index Fund (LQD). Such an allocation allows investors to reap the cost benefits of a pool while having access to the flexibility, intraday liquidity and other benefits of the ETF. Some who held a small portion of LQD during the credit crunch found it was the only fixed income instrument they could trade to reduce their credit exposure or raise cash.

That speaks to a key benefit of ETFs in general: holding part of an asset class in ETFs enables investors to easily adjust their exposure to that class. Most importantly, they can do it quickly and at a transparent price. Particularly in the fixed income space—where the underlying market is often neither liquid nor price-transparent—the unique characteristics of exchange traded funds have the potential to be even more beneficial to institutional investors.

Bill Chinery is managing director, BlackRock Asset Management Canada Limited

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