ETF Store Insight

3 Ways ETFs Have Revolutionized The Bond Market

July 26th, 2017 by ETF Store Staff

The following was authored by Matthew Tucker, Head of iShares Americas Fixed Income Strategy.

Fifteen years ago this week the first bond exchange-traded funds (ETFs) debuted, changing the way investors can access fixed income markets. At first, only four iShares bond ETFs were available, with just a small amount of assets and access limited to Treasuries and U.S. investment grade credit. Today there are over 300 bond ETFs in the U.S. with more than $500 billion in total asset under management (AUM), offering entry into almost every sector of the bond market (source: BlackRock and Bloomberg, as of 6/30/2017).

What brought about this exceptional growth? Quite simply, ETFs have modernized fixed income markets. They can help make it easier for both retail and institutional investors to invest in bonds, potentially gain liquidity and add specific exposures to portfolios.

Total assets under management for bond ETFs (U.S. total)

chart-total-assets

Easy access to bonds

Traditionally, the over-the-counter nature of the bond market favored larger, more sophisticated investors—size and scale mattered in everything from trade execution to getting allocations for new issues. Bond ETFs help level the playing field. They enable investors to efficiently access fixed income markets on demand. With a single ticker, an investor can tap into thousands of bonds in a specific sector without having to hunt for inventory or navigate multiple offers from multiple brokers. Bond ETFs have democratized access to this marketplace. An individual investor in Kansas can trade bond ETFs on a stock exchange in the same way as a hedge fund manager in New York would.

Ease in trading in and out of bond ETFs

The liquidity offered by bond ETFs is another reason for the market’s remarkable growth. Most bonds trade over the counter, while bond ETFs trade on the exchange.  Exchange trading creates liquidity and allows for bond ETFs to be used to manage risk and adjust market exposure. In their 2016 U.S. Bond ETF Study Greenwich Associates noted that 71% of surveyed institutional investors have found that the trading, sourcing and liquidity of fixed income securities have become more challenging over the last three years. About 85% of institutions that invest in ETFs said that they use bond ETFs due to their liquidity and low trading costs. (Source: Greenwich Associates. ETFs: “Active” Tools for Institutional Portfolios, 2017. This study was sponsored by BlackRock.)

Why are bond ETFs more liquid than individual bonds? Because the over-the-counter bond market can be very illiquid. Not every bond trades everyday, based on comparing 30-day trading data from TRACE to broad Bloomberg and Markit bond market indexes as of 6/30/2017. For those investment grade and high yield bonds that are considered liquid, represented by constituents in Markit iBoxx $ Liquid Investment Grade and High Yield Indexes, they only trade 3-4 times per day on average. By comparison, bond ETFs trade at significantly higher frequency. For example, iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), an investment grade ETF, trades 14,000 times a day. iShares iBoxx $ High Yield Corporate Bond ETF (HYG), a high yield ETF, trades 32,000 times a day. (Based on 30-day trading data from BlackRock, Bloomberg, TRACE and Markit iBoxx, as of 6/30/2017).

Bond ETFs add incremental liquidity to the bond markets by allowing investors to trade shares on an exchange. Investors are effectively trading portfolios of bonds at a visible price on the exchange, and most of these transactions do not involve any actual bonds being traded. Bond ETFs allow investors to access bonds the same way they can access stocks.

Express views with precision

Before ETFs, many investors relied on active mutual funds or individual securities for access to the bond market. They had to know the ins and outs of security selection (e.g. credit research, issuer analysis), or find an active manager with their same view on the market.

Now investors can use bond ETFs to build model portfolios, follow asset allocation guidance, or express their own tactical views, all in a low-cost manner. Bond ETFs have put investors back in the driver’s seat. An investor can take control of their portfolio risk by using bond ETFs that seek to track an index. For example, investors seeking exposure to investment grade bonds know that an index investment grade bond ETF will only hold these bonds, and won’t dip into high yield securities. Investors knows what they are invested in—and what they won’t be invested in down the road.

With 15 years of history, bond ETFs have weathered the global financial crisis, quantitative easing and several rounds of interest rate hikes. Even with the $700 billion in assets today, bond ETFs represent less than 1% of the global bond markets (source: SIFMA and Bloomberg, as of 6/30/2017). If the growth in equity ETFs were any indication, bond ETFs could continue to grow at double digits and reach $2 trillion in the next 15 years.

For investors who are looking to get started with bond ETFs, consider a broad fund like iShares Core U.S. Aggregate Bond ETF (AGG) or iShares Core Total USD Bond Market ETF (IUSB). Investors who are more interested in building a custom portfolio, the Core Builder Tool on iShares.com can help.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog. Karen Schenone, CFA, is a Fixed Income Product Strategist and contributed to this post.

 


Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

Additional information on the differences between ETF and mutual funds may be found here.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.

Diversification and asset allocation may not protect against market risk or loss of principal.

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