FIXED INCOME ETFs AND THE CORPORATE BOND LIQUIDITY CHALLENGE

Transcription

1 FIXED INCOME ETFs AND THE CORPORATE BOND LIQUIDITY CHALLENGE

2 about the authors Mr. Tucker is a member of BlackRock s Fixed Income Portfolio Management Team. He leads the product strategy effort for exchange traded funds, and leads the platform s efforts in North and Latin America ishares. His team focuses on developing new fixed income ishares strategies, partnering with the ishares team on product delivery, and supporting ishares client sales. MATTHEW TUCKER, CFA Managing Director Mr. Tucker s service with the firm dates back to 1996, including his years with Barclays Global Investors (BGI), which merged with BlackRock in At BGI, he led the US Fixed Income Investment Solutions team, where he was responsible for overseeing product strategy for active, index, enhanced index, ishares (ETF) and long/short products. Previously, he was a portfolio manager and trader in fixed income focused on US government securities. Mr. Tucker began his career at Barra, where he supported clients in the use of Barra s fixed-income analytics. Mr. Tucker earned a BS degree in business administration from the University of California at Berkeley in 1994 and is a CFA Charter Holder. Steve Laipply is a Director in BlackRock s Fixed Income Portfolio Management Group. Mr. Laipply s service with the firm dates back to 2009, including his years with Barclays Global Investors (BGI), which merged with BlackRock in At BGI, he was a senior investment strategist on the U.S. Fixed Income Investment Solutions team, responsible for developing and delivering fixed income solutions to clients. STEPHEN LAIPPLY Director Mr. Laipply focuses primarily on the ishares (ETF) fixed income product suite. Prior to joining BGI, he was a senior member in both of the Strategic Solutions and Interest Rate Structuring Groups at Bank of America Merrill Lynch, where he structured and marketed fixed income solutions across interest rates, credit and mortgages to institutional investors. Mr. Laipply earned a BS degree in finance from Miami University, and an MBA in finance from the University of Pennsylvania. [1] Fixed Income ETFs and the Corporate Bond Liquidity Challenge

3 Overcoming the Corporate Bond Liquidity Challenge Investors today face a number of liquidity challenges in the corporate bond market. Liquidity, measured by both trading volumes and average trade size, has seen limited growth since 2007 despite record bond issuance over the same period. In the over-the-counter (OTC) corporate bond market there is a fragmentation of issuance, whereby dozens or even hundreds of unique securities are issued by the same entity. This dilutes security-level liquidity as investors are forced to grapple with a myriad of bonds with different coupon levels, call structures, and maturity dates for a given issuer. Given this fragmentation, corporate bonds face discontinuous liquidity where many individual securities trade infrequently. In 2013, 37% of the 37,000+ TRACE eligible bonds did not trade even once, which made it difficult for investors to liquidate or purchase securities. At the same time, the financial crisis and subsequent reforms led to a reduction in the amount of capital that banks, brokers and other traditional liquidity providers commit to supporting secondary bond trading. This further reduced the tradable supply of bonds, impacting investors efforts to source securities, as well as their efforts to get bids on positions. BlackRock believes that there are four developments within the fixed income market that will help address the market s liquidity challenges. 1 Standardize 2 Connect 3 Modernize 4 Change A move to a more standardized benchmark issuance cycle would allow issuers to pool investor interest into a smaller number of larger issues, increasing liquidity in those securities while also lowering borrowing costs. This recommendation was described in detail in the BlackRock Investment Institute s recent publication, The Liquidity Challenge II. The traditional bond trading models of dealer-to-dealer and dealer-to-client are no longer sufficient. We advocate an all-to-all paradigm that includes alternative liquidity sources. These could include crossing networks that electronically match large orders, along with ETFs that facilitate the trading of baskets of securities on a platform accessible by all investors. We are traveling from the traditional request-for-quotation practice (buyers call a dealer for a quote on a bond) toward a centralized order book (full transparency of all bids and offers in the entire marketplace). Developments such as ETFs that trade in a visible exchange market are an important step in this journey. All bond market participants, in particular issuers (who hold the keys to unlocking the log jam), need to rethink their existing practices and priorities, as explained in our Five Questions to Consider in Setting New Standards. ishares [2]

4 THE ROLE OF ETFs IN IMPROVING BOND LIQUIDITY Over the past five years, we have seen a surge in the growth of the relatively new corporate bond ETF market, which has outpaced the growth of the more mature corporate bond market. From Dec. 31, 2007, to Dec. 31, 2013, the corporate bond market grew 81% from $2.6 trillion to $4.7 trillion. Over the same time period, the amount of assets in investment grade and high yield corporate bond ETFs jumped from $3.9 billion to $100.4 billion, a 25-fold increase. Even with this growth ETFs remain a fraction of the size of the underlying market. FIGURE 1: GROWTH IN AUM IN CORPORATE ETFs VS. CORPORATE MARKET Corporate Bond Market Value ($bn) Corporate Bond Market Value Credit ETF Total AUM Source: Barclays, Bloomberg as of 12/31/2013. Corporate Bond Market Value represented by the sum of the market values of the Barclays US Corporate and Barclays US High Yield indices. [3] Fixed Income ETFs and the Corporate Bond Liquidity Challenge

5 The growth in fixed income ETF assets under management (AUM) has been accompanied by an almost ten-fold increase in exchange trading volumes over the same time period as investors have looked to utilize ETFs as bond liquidity vehicles. The increases in ETF trading volume have come despite sluggish growth in OTC bond liquidity over the same period. As a result, the amount of liquidity available through ETFs as a percentage of the corporate bond market has grown steadily. Importantly, volumes in ETFs have risen during periods of market dislocation. During times of market stress, investors look to liquid vehicles to reposition portfolios and adjust to rapidly shifting market conditions. As an example, trading volumes in the ishares iboxx $ High Yield Corporate Bond ETF (HYG) tend to become elevated during these stressed markets. When investor sentiment for high yield shifted in Q2 2013, we saw consistent outflows from HYG and other high yield ETFs and mutual funds. At the same time, HYG s average daily volume (ADV) spiked from $291 million on Apr. 30, 2013, to $775 million on Jun. 21, In fact, HYG posted 5 days of exchange trading volume in excess of $1 billion in May and June of We observe this same phenomenon with ETFs in other markets as well. The ishares Emerging Market Equity ETF (EEM) is a classic example. EEM provides diversified access to a broad cross section of the local EM equity market. While many of these markets are difficult to access directly, EEM serves as a highly efficient exposure vehicle similar to the way in which HYG allows investors to efficiently access the USD FIGURE 2: DOLLAR VOLUME OF ishares iboxx $ INVESTMENT GRADE CORPORATE BOND ETF (LQD) & ishares iboxx $ HIGH YIELD CORPORATE BOND ETF (HYG) AS PERCENTAGE OF CASH BONDS 3.5 LQD + HYG Volume/Cash Bond Volume (%) May 07 Dec 07 May 08 Dec 08 May 09 Dec 09 May 10 Dec 10 May 11 Dec 11 May 12 Dec 12 May 13 Dec 13 Source: Barclays, Bloomberg as of 12/31/2013. LQD and HYG Volume / Cash Bond Volume is calculated as the from the 20-day average of HYG and LQD volumes divided by the 20-day average of TRACE corporate bond volumes. ishares [4]

6 high yield bond market. Like HYG, EEM s trading volume tends to accelerate during periods of market dislocation. During 2008, equity emerging markets were under severe pressure and over the year EEM s share price fell by more than 50% from $50.04 on Dec. 31, 2007, to $24.94 on Dec. 31, Over this same period, EEM s average monthly dollar volume rose by 59% from $36.8 billion to $58.4 billion by the end of Despite the share price of EEM falling by half during the period, the share volume increased almost fourfold. For larger, seasoned ETFs, the majority of risk is traded on the exchange, independent of the OTC bond market. In order to quantify this effect, we can examine the ratio of ETF exchange transaction volume to fund creations/redemptions through time. This ratio represents the liquidity efficiency of the ETF or the incremental amount of corporate bond liquidity available to investors through the ETF structure. When this ratio is high, say 10:1, it means that for every $10 of ETF liquidity that was provided on the exchange, only $1 of liquidity was required from the OTC bond market through the creation/redemption process. When this ratio is low, say 1:1, it means that the ETF is not providing any incremental liquidity to the market and that all ETF exchange transactions result in a commensurate amount of OTC bond activity. MECHANICS OF NEW ETF SHARE CREATION Investor (buyer) Advisor/ brokerage account Cash ETF shares ETF market maker Basket of securities ETF creation units Fund company Securities Cash Capital markets Increases and decreases in ETF trading volume do not occur in isolation. Purchase and sale orders of ETFs can be accommodated on the exchange, but when there is a supply/ demand imbalance, ETF shares will likely be created or redeemed. This will typically occur when the ETF market price is trading above or below the actionable price of the underlying bond portfolio. Such activity essentially represents the excess supply or demand for an ETF being reconciled through increases or decreases of ETF share supply via the OTC bond market. OTC bond trading activity is necessary to facilitate inflows and outflows from ETFs, through a creation or redemption of fund shares by Authorized Participants ( APs ). A creation of new fund shares will potentially result in bond purchases by the AP (unless the AP is already holding the requisite bonds in inventory), while a redemption of shares will potentially result in bond sales by the AP. [5] Fixed Income ETFs and the Corporate Bond Liquidity Challenge

7 The secondary/primary volume ratio for funds tends to increase through time as ETF liquidity grows. The ratio itself can be very volatile depending on the direction and magnitude of investor sentiment. For HYG and LQD this ratio has tended to be around 6:1. During balanced markets, where there are close to equal numbers of buyers and sellers of the ETF, the ratio can spike as the vast majority of investor transactions are conducted on the exchange and the level of creation/redemption volume is low. We saw this in August 2009 when the combined ratio for the two funds exceeded 20:1. Conversely, when investor sentiment is more homogenous we can see a strong preference for either buying or selling. In these markets a larger number of creations and redemptions will likely occur as a comparatively smaller amount of transactions are able to be matched off on exchange. We saw such a period in January 2012 when the ratio fell to approximately 2.5:1. FIGURE 3: SECONDARY TO PRIMARY RATIO OF HYG AND LQD Secondary to Primary Market Ratio May 07 May 08 May 09 May 10 May 11 May 12 May 13 Source: Bloomberg as of 9/30/2013. Ratio calculated as the monthly total exchange volume of HYG and LQD divided by gross flows. To put this in context, we can again look at the behavior of EEM. As the EEM fund has grown, and liquidity has increased, the secondary/primary ratio for the fund has steadily increased. It went from just over 1:1 at launch to an average in excess of 20:1 in Like HYG, we also observed significant spikes in volume during periods of market volatility. During 2008, the ratio exceeded 50:1 at times. During August 2012, this ratio peaked at 250:1. An examination of the trading histories of HYG and EEM reveals similar liquidity growth patterns, although EEM is further along as it has benefited from more time in the market and greater adoption. FIGURE 4: SECONDARY TO PRIMARY RATIO OF EEM Jul 03 Jul 05 Jul 07 Jul 09 Jul 11 Jul 13 Source: Bloomberg as of 9/30/2013. Ratio calculated as the monthly total exchange volume of EEM divided by gross flows. ishares [6]

8 The growth of the fixed income ETF market has helped to create a new, incremental source of liquidity for investors, above and beyond that which can be accessed directly in the OTC bond market. The ETF effectively provides an additional trading venue the exchange where fixed income risk can be transferred among investors. This additional layer of exchange liquidity increases the total amount of liquidity available to fixed income investors. The corporate bond market is highly fragmented, but in some respects, liquid ETFs such as LQD and HYG have developed into standardized vehicles for liquid, on-the-run issues as well as less liquid off-the-run issues. There are over 1,100 positions in LQD s index 1. LQD essentially packages these securities into a portfolio that is then traded on the exchange. Each transaction in LQD is essentially a transaction in a pro-rata slice of LQD s holdings. This is somewhat similar to how CDX has impacted single name CDS. INVESTOR USAGE OF FIXED INCOME ETFs ETFs like LQD and HYG have become more liquid and are increasingly being adopted by institutions such as insurance companies, asset managers, and pension funds. This is consistent with a broader trend towards increased ETF usage on behalf of institutional investors. A 2013 Greenwich survey found that 37% of institutional investors expect to increase ETF usage in 2014, with only 20% expecting to reduce usage. A full 53% of these respondents expect to use ETFs for tactical applications such as interim beta, transitions, and tactical portfolio adjustments. We can see evidence of increased institutional usage in the trading behavior of fixed income ETFs. As fund liquidity has increased, so too has the frequency of large trades institutional-sized block trades. In 2009, block trades (defined as single trades in excess of $10 million in size) accounted for just 10% of LQD s trading volume and 8% of HYG s trading volume. These percentages steadily increased to over 17% for both HYG and LQD in FIGURE 5: LARGE TRADES AS A % OF TRADING FOR LQD AND HYG 30% 24% Value ($M) 18% 12% 6% 0 Mar 09 Sep 09 Mar 10 Sep 10 Mar 11 Sep 11 Mar 12 Sep 12 Mar 13 Sep 13 High Yield (HYG) Investment Grade (LQD) Source: BlackRock, Bloomberg as of 12/31/2013. Graph shows the total value of single trades over $10m as a percentage of total dollar trading volume for the previous three months 1. Source: Market data as of December 31, [7] Fixed Income ETFs and the Corporate Bond Liquidity Challenge

9 It should be noted that, although fixed income ETFs have created an incremental source of bond market liquidity for investors, the ETF structure itself remains dependent on the liquidity of the underlying bond market. ETFs serve as efficient risk transfer vehicles because the value at which they trade is reflective of the value of the underlying bonds held within the ETF. If a true and actionable value discrepancy between the ETF and its underlying bond portfolio develops, market participants can trade one versus the other to take advantage of the arbitrage opportunity. This mechanism is premised upon a functioning OTC bond market that can be accessed to buy and sell the underlying securities. Ultimately, if the underlying bond market liquidity becomes impaired then the ETF creation/redemption process would become impaired as well. In such a scenario the ETF would continue to provide price discovery, but would mechanically begin to function more like a closed-end fund (which is unable to grow or shrink in size in order to balance supply and demand). While ETFs provide liquidity enhancement for the bond market, they remain structurally dependent upon the same market. DEALER INVENTORY RISK REDUCTION Fixed income ETF liquidity simultaneously provides an alternative venue for transferring fixed income risk while also serving as a buffer between fund buying/ selling pressure and the OTC market. This important attribute can be beneficial to dealers, particularly in the current environment. It has been well documented that dealers corporate bond balance sheets have declined in recent years. According to data from the New York Federal Reserve, the amount of corporate bonds and other fixed income securities held on balance sheet by primarily dealers has declined from $230 billion in 2007 down to just over $50 billion as of Q Interestingly, the growth in the size of the corporate bond ETF market has coincided with the decline in dealer corporate bond holdings. As dealers have pared back balance sheets and traditional warehousing activity, an increasing amount of corporate bond risk transfer appears to be occurring on exchange through fixed income ETFs. ishares [8]

10 Unlike conventional pooled vehicles which operate on a direct subscription/ redemption basis, dealers will not create or redeem shares in the ETF unless: 1. The ETF market price dictates such action relative to the actionable trading price of the underlying bond portfolio; and 2. Dealers are certain that they can acquire, carry, or dispose of the underlying portfolio economically. FIGURE 6: VALUE OF PRIMARY DEALER POSITIONS AND CORPORATE ETF AUM $250 $200 Value ($B) $150 $100 $50 0 Mar 03 Mar 05 Mar 07 Mar 09 Mar 11 Mar 13 Credit ETF Assets Primary Dealer Positions Source: Bloomberg, Federal Reserve Bank of New York as of 3/31/2013. Contrast this with conventional pooled vehicles (e.g. mutual funds, CTFs) in which dealers are continuously asked to bid or offer bonds in response to changes in fund demand. The market price on the exchange for a fixed income ETF provides a risk clearing level for the portfolio of bonds held in the ETF, even if the individual bonds are not frequently trading in the OTC market. The exchange market price signal of the ETF can potentially help dealers better optimize their warehousing activity in the face of increased regulatory and liquidity constraints. As there are now effectively two venues in which to transfer fixed income risk (the OTC market and the exchange through the ETF), dealers can choose to transfer risk through the exchange or through individual OTC bond transactions according to the levels of value and liquidity presented in both markets. ENHANCING PREDICTABILITY FOR ISSUERS As passive vehicles such as fixed income ETF vehicles grow, they increase the predictability of demand for new issues. Index funds are typically benchmarked to indices that are rules driven and market capitalization weighted. Securities that meet the specified rules of the index are included in the benchmark. As a result, about 70% of investment grade issuance has been historically eligible for inclusion in a broad index such as the Barclays Credit Index. ETFs and other passive vehicles essentially represent a standing bid for index eligible bonds in general and new issues in particular as such vehicles will generally seek to attain a market capitalization weighting of the new security. [9] Fixed Income ETFs and the Corporate Bond Liquidity Challenge

11 FIGURE 7: % OF INDEX ELIGIBLE NEW ISSUANCE 100% 75% 50% 25% 0% Source: Bloomberg, Barclays as of 12/31/2013. Although new issues do not typically enter into a fixed income index until the end of the month in which they are issued, index funds and ETFs routinely take part in the new issuance process as the index that they track transitions into the forward index through the index rebalancing cycle. In some cases, new issuance comes at a concession, providing an opportunity for the index fund to scale into the position more cost effectively. New issues can also witness excessive demand, creating challenges for index funds that attempt to build their target position in the secondary market. By accessing the primary market, index funds are able to take advantage of the issue s initial liquidity as well as get a lead on building a position that will be included in the index at month end. The growth of ETFs could therefore become a driver of issuer standardization. As ETFs and other passive vehicles would be a natural buyer for large, liquid issuance, issuers may become more likely to issue index eligible securities. THE FUTURE OF FIXED INCOME ETFs Further market standardization could be driven by the growth and adoption of fixed maturity ETFs, such as ibonds. The new structure of fixed maturity ETFs has created pooled term-specific fixed income vehicles that combine the exchange trading features described above with a pre-determined investment horizon; a necessary feature for many liability focused investors. The term- maturity ETFs can be used in a similar manner to individual bonds. Investors can purchase and trade specific points on the curve using a diversified basket of bonds that can help mitigate individual issuer risk. The continued growth in the size and liquidity of term maturity ETFs could eventually result in such vehicles serving as market benchmarks for specific fixed income maturities. For example, investors could use a 10-year corporate bond term maturity fund as a reference point for security specific pricing. The term maturity ETFs could also become a reference benchmark in volatile markets as all investors could observe changes in the valuation of specific curve points in real time. Such developments would be beneficial to all market participants as it would create a reference benchmark that is visible, investible and of similar credit quality to the security being traded. Eventually such vehicles may have the potential to synchronize standardized issuance curve points as new issues entering the market could be priced relative to the liquid term maturity ETF of the same tenor. ishares [10]

12 CONCLUSION With a current size of over $280 billion, the fixed income ETF market is quickly becoming a core part of the fixed income landscape in the U.S. Growth in fund size and liquidity has resulted in increased adoption of ETFs by a wide cross section of investors, from individuals to wealth managers, institutional asset managers, insurance companies and pension funds. Many of these investors are driven to explore ETFs as a valuable new source of liquidity in a market that has witnessed growing transaction challenges. Consequently, fixed income ETFs are being used alongside individual bonds and derivative instruments as part of a fixed income investors toolkit. Investors now have the ability to quantify and evaluate the tradeoffs in each of these three markets, and are able to select the instrument that allows for the most efficient implementation of their desired strategy. The continued development of ETFs will play a vital role in the improvement of fixed income liquidity and the evolution of the bond market. Passive fixed income ETFs track benchmarks which are governed by defined inclusion and exclusion rules. As part of standardization, issuers may find better reception and liquidity by issuing bonds that are ETF eligible, and ETFs may serve as a more predictable source of demand for new issues. As fixed income ETFs allow investors to access liquidity across both the over the counter (OTC) market and the exchange, they allow participants to connect buyers and sellers more readily than through the OTC market alone. Similarly, fixed income ETFs serve a modernizing function given that they represent baskets of bonds trading on exchange in a displayed two-way market. The exchange price can provide valuable price discovery with respect to the underlying OTC portfolio. Finally, fixed income ETFs are enabling market participants to change the manner in which they source and trade fixed income risk by providing an alternative venue for access and liquidity. is Carefully consider the ishares Funds investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds prospectuses and, if available, summary prospectuses, which may be obtained by calling iShares ( ) or by visiting Read the prospectus carefully before investing. Investing involves risk, including possible loss of principal. Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity. In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Diversification may not protect against market risk or loss of principal. Shares of the ishares Funds may be sold throughout the day on the exchange through any brokerage account. However, shares may only be redeemed directly from a Fund by Authorized Participants, in very large creation/redemption units. Although market makers will generally take advantage of differences between the NAV and the trading price of ishares Fund shares through arbitrage opportunities, there is no guarantee that they will do so. The ishares Funds are not sponsored, endorsed, issued, sold or promoted by Markit Indices Limited, nor does this company make any representation regarding the advisability of investing in the Funds. BlackRock is not affiliated with Markit Indices Limited. The ishares Funds and BlackRock Mutual Funds are distributed by BlackRock Investments, LLC (together with its affiliates, BlackRock ) BlackRock, Inc. All rights reserved. BLACKROCK, ibonds and ishares are registered and unregistered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are those of their respective owners c_PRD_v01BM_0515 Not FDIC Insured No Bank Guarantee May Lose Value