In the first half of 2015, investors put $24 billion of fresh money into fixed income ETFs, pushing the total asset base to more than $325 billion. While bond ETFs were just 0.4% of the global bond market at year end, there remains concern that bond market liquidity may deteriorate in light of ETF competition during stressed conditions such as pending Federal Reserve activity. As such we think it is worth digging into how bond ETFs operate and what investors did during recent times of market uncertainty, including 2008, 2013 and 2014.
While bonds do not trade on an exchange, bond ETFs do and receive the benefits of transparency and intra-day access. When sellers of bond ETF shares exceed buyers, the price of the ETF declines, just as it would for equity securities. If the price of the ETF shares deviates from the net asset value of the ETF’s holdings, traders, including authorized participants, can take advantage of the valuation deviation by acting against this market trend. They would purchase an ETF when it trades at a discount and short the ETF if it trades at a premium.
Yet bond ETF trading activity should not be confused with bond buying and selling. Unlike with a mutual fund, ETF shareholders typically trade with one another through the exchange.
iShares Core US Aggregate Bond (AGG), a broad-based investment-grade bond ETF with $25 billion in assets had 6.2 times the number shares traded in the secondary market during the first half of 2015 than the net shares that were created/redeemed. Meanwhile for Vanguard Total Bond Market (BND), a peer of AGG with $26 billion in assets, the ratio ranged 3.8 times to 7.5 times between 2007 and mid-2015. The peak of secondary volume occurred during the financial crisis in mid-2008, just as bond liquidity was declining.
Meanwhile, iShares iBoxx High Yield Corporate Bond (HYG), which focuses on a less liquid, speculative-grade market has $14 billion in assets. The ETF traded 4.8 times more frequently on the secondary market than the total shares created/redeemed in the first half of 2015. During the summer of 2013, the Federal Reserve unexpectedly announced it would begin tapering back its $70 billion monthly bond program, causing widespread fears of higher interest rates. Even as bond prices declined sharply in June 2013, volume in HYG spiked sharply to 25% of the underlying market, according to BlackRock. To S&P Capital IQ, this makes the argument from Carl Ichan last week that ETFs will cause havoc in the high yield market, hard to justify.
Let’s fast forward to the late September 2014 departure of Bill Gross as Chief Investment Officer of PIMCO and manager of the sizable actively managed PIMCO Total Return (PTTRX) mutual fund. During this “key-man risk” two-plus month period, $60 billion stampeded out of PIMCO with some shifting to low-cost liquid ETFs as they assessed their alternatives. Indeed, in the two months following his exit, AGG saw $3 billion of net inflows. This was four times the inflows the ETF, which has only a 0.08% net expense ratio, gathered in the prior two months.
AGG is one of 62 fixed income ETFs we track that traded with a $0.03 or lower bid/ask spread, allowing investors to easily get in and out of a portfolio of hundreds or thousands of bonds. For many investment styles the cost of trading individual bonds is much more expensive.