Introduction to Fixed Income Exchange Traded Funds (ETF)

Transcription

1 Introduction to Fixed Income Exchange Traded Funds (ETF) Raman Suri Managing Director, ishares Insurance Katie Garvey Vice President, ishares Insurance

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3 Agenda I. What are Fixed Income ETFs? II. III. IV. Benefits of ETFs ETF Industry ETF application by insurers V. Accounting and Regulatory Overview VI. Appendix For Institutional Clients Only-- Not for Public Distribution 3

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5 What are Fixed Income Exchange Traded Funds?

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7 What are fixed income ETFs? Fixed income ETFs are funds that hold a portfolio of bonds (like a mutual fund) but trade on an exchange. They are listed and traded on an exchange Trading flexibility intraday They provide exposure to segments of the fixed income market Broad markets, like the total US bond market (Barclays Aggregate Index) Targeted segments by sector, quality or maturity They are index funds Consistent diversified exposure Track a specific index Low expense ratios Low turnover They are often designed to be tax efficient ETF creation/redemption mechanism can reduce capital gains distributions In 2012, only 5 ishares fixed income ETFs (out of a total of 51) paid capital gains Exchange Traded Securities Liquid and tradable during the day ETFs Diversified funds that trade on exchange Mutual Fund Diversified pool FOR INSTITUTIONAL INVESTORS ONLY NOT FOR PUBLIC DISTRIBUTION 7

8 How Traditional Mutual Funds Work Buyers Mutual Fund Company Stock Exchange Sellers Investors Interact with the Fund to Purchase or Redeem Shares FOR FINANCIAL PROFESSIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 8

9 ETFs Work Differently than Traditional Mutual Funds Buyers Sellers Stock Exchange Authorized participants In-kind transfer ishares Investors are Insulated From Each Other, and In-Kind Transfer Helps Clear Low Cost Basis Positions, Improving Tax-Efficiency FOR FINANCIAL PROFESSIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 9

10 Why are fixed income ETFs different? Bond markets Equity markets In the over-the-counter (OTC) bond market, buyers and sellers negotiate one-on-one to reach a deal for each bond. Bonds can be hard to find, and an investor may get different prices from different brokers. This opaqueness Where can I find bonds? Can I get a good price? is a defining characteristic of the OTC bond market. Most stocks are traded on centralized exchanges, such as the NYSE. Through the exchange, investors can easily see execution prices throughout the trading day. Fixed income ETFs provide transparency to the bond market, allowing investors to trade bonds like stocks 10

11 Layers of liquidity Bottom line: a fixed income ETF will be at least as liquid as the underlying cash bonds in the portfolio, and often offers additional liquidity through the exchange. ETF Liquidity Represents the displayed ETF liquidity readily visible and available to trade Non-displayed liquidity (i.e., supply held by market makers and large institutional holders) allow for excess ETF liquidity to be accessed through more sophisticated trading strategies Displayed Liquidity Non-Displayed Liquidity Underlying Liquidity If the ETF liquidity is insufficient, the liquidity of the underlying bonds can be accessed via the creation/redemption process Underlying Bond Portfolio Liquidity There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 11

12 What do ETF investors actually hold? ETF shares represent a pro-rata slice of the portfolio of securities in the fund Authorized Participants have the option to redeem their shares in the ETF for a vertical slice of the bonds within it Concurrently, ETF investors also have the option to use their existing portfolio to create shares of an ETF ishares Core Total U.S. Bond Market ETF (AGG) Portfolio Individual ETF Investor Portfolio (AGG) Portfolio Breakdown Treasuries 35.7% MBS 29.8% Credit 28.3% Agencies 4.0% CMBS 1.7% ABS 0.5% Barclays U.S. Aggregate Bond Index 100% Source: BlackRock For illustrative purposes only. is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 12

13 Legal and structural design of ETFs ETF design helps protect shareholders 1. Almost all ishares ETFs are set up as separate investment portfolios under the Investment Company Act of The custodian maintains the securities and assets of each Fund in separate accounts. 3. The assets in an ETF are separate and distinct from the assets of the various service providers such as asset managers, index providers, custodians, etc. 4. Generally the ETF is not directly subject to the credit risk of a service provider. is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 13

14 Understanding ETF liquidity ETFs as a bouquet of flowers - video is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 14

15 Creation and redemption process The ability to trade an ETF on-exchange and create and redeem shares work to create an equilibrium of liquidity The supply and demand of an ETF is managed by market participants (e.g. market makers, authorized participants) If a large order to buy or sell shares of an ETF exceeds on-exchange liquidity, market participants react accordingly to create or redeem shares of the ETF ETF Supply ETF Demand The creation/redemption process typically can maintain an equilibrium of liquidity in the market REDEEM When there is excess ETF supply and the price of the ETF is out of line with value of underlying securities, market participants remove ETF shares from the market by exchanging shares of the ETF for the underlying securities CREATE When there is excess ETF demand in the market, market participants add ETF shares to the market by exchanging the underlying securities for shares of the ETF Shares of 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. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 15

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17 Benefits of ETFs

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19 Bond ETFs offer key advantages Low cost Often pay less to invest Diversification Access many bonds in a single trade Liquidity Get in and out when it counts Transparency Know exactly what you own every day FOR INSTITUTIONAL INVESTORS ONLY NOT FOR PUBLIC DISTRIBUTION 19

20 ETFs offer cost effective market access for less Lower Transaction Costs Transactions costs, in the form of bid-offer spreads, can be high in the bond markets ishares ETFs tend to trade at much tighter bid-offer spreads than the underlying bond market Fees and Expenses The average bond mutual fund has a 1.02% expense ratio and a 0.7% front-end sales load ishares ETFs typically have much lower expense ratios and do not charge front or back end sales loads Bid/Offer Spread (bps) ishares Bid/Offer Bid/Offer of Underlying (est.) AGG LQD HYG MUB TLT SHY 2 Category Intermediate Term Bonds Municipal Bonds Avg. Mutual Fund ishares ETF 0.92% 0.08% (AGG) 0.86% 0.25% (MUB) High Yield 1.15% 0.50% (HYG) Emerging Market Bonds 1.26% 0.60% (EMB) Fixed income ETFs offer bond market access at a lower cost Sources: BlackRock, Bloomberg, Barclays, Morningstar, Investment Company Institute, as of February Underlying bid/offer data based on actual spreads of underlying bonds. Buying and selling shares of ishares Funds will result in brokerage commissions. is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 20

21 Diversification: access several bonds with a single trade in an ETF Getting sufficient diversification in the cash bond market (especially for smaller amounts) can be challenging There are also typically higher transaction costs on odd lots With the ishares Core Total U.S. Bond Market ETF (AGG), you can access the entire US investment grade bond market and over 2,300 bonds in a single trade. ishares Core Total U.S. Bond Market ETF AGG Government Credit Securitized US Treasuries 36.8% Corporates 21.9% Mortgage-Backed Securities (MBS) 28.5% Issued and backed by the full faith and credit of the US government Issued by corporations to finance operations Backed by a pool of residential mortgage loans US Agencies 5.1% Non-Corporate Credit 5.4% Commercial Mortgage- Backed Securities 1.9% Issued by US government agencies that carry an explicit or implicit government guarantee Issued in the US by foreign governments, foreign agencies or municipalities that are subject to federal income tax (i.e. sovereigns, foreign agencies, supranationals and taxable munis). Backed by a pool of commercial mortgage loans Adjustable Rate Mortgages (ARMs) 0.8% Source: BlackRock, as of 2/28/2013. Allocations subject to change. Diversification may not protect against market risk or loss of principal. Backed by mortgage loans with adjustable interest rates is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 21

22 Liquidity: ETFs help address challenges with bond trading Most bonds do not trade daily The underlying bond market can be very illiquid and individual bonds can trade very infrequently. Most investment grade and high yield corporate bonds have historically traded fewer than half the days each month (see below). Finding actionable bids & offers in volatile markets can be particularly challenging ishares bond ETFs can trade millions every day Constructing broad credit portfolios from bonds available at dealers can be challenging given low inventory levels and market fragmentation Because ETFs trade on an exchange, investors can access bonds as easily as they can access stocks. 250, ,000 Primary Dealer Positions Credit ETF Assets Value ($M) 150, ,000 50,000 - Sep-02 Dec-02 Mar-03 Jun-03 Sep-03 Dec-03 Mar-04 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 ETFs offer investors ability to increase or decrease their fixed income exposure more easily Source: BlackRock, Bloomberg as of 3/31/2013. Primary dealer inventory is measured by the Primary Dealer Positions Outright Level of Corporate Securities Due Greater Than 1 Year. Credit ETF assets include US listed corporate and credit bond ETFs, excluding leveraged or inverse funds, bank loan funds, floating rate funds and convertible funds. is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 22 22

23 Liquidity: ETFs offer outlet in volatile markets ETFs can provide liquidity during volatility May and June of 2013 saw stress in the fixed income markets as investors began to worry about the Fed removing liquidity by tapering quantitative easing measures During this time, many fixed income investors used ETFs to express their views as ETF prices represented actionable trading prices while underlying bonds saw limited trading HYG Exchange Volume Relative to OTC HY Volume (TRACE) HYG $Volume / HY TRACE $Volume (%) Fed tapering fear 10 8 Financial Crisis UST downgrade May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Source: BlackRock, Bloomberg as of 6/28/13 is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 23

24 Transparency Single share class ETFs offer complete daily transparency into underlying holdings. Evaluate ETFs and their individual components: View details on each underlying CUSIP in the portfolio (e.g., maturity, coupon, sector, rating, etc.) View risk characteristics such as effective duration, effective convexity, partial durations, and OAS Understand the impact of including ETFs in your portfolios: Assess your combined portfolio s industry, asset, ratings, and sector-level exposures Perform total return / horizon analysis on ETF and portfolio holdings across different scenarios Portfolio analytic solution providers (e.g. Bloomberg, BondEdge, Yield Book) have integrated many bond ETFs into their platforms. FOR INSTITUTIONAL INVESTORS ONLY NOT FOR PUBLIC DISTRIBUTION 24

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26 ETF Industry

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28 Growth of exchange traded funds in the US $2,000 Increasing adoption of exchange traded products (ETPs) 1 $1, year CAGR for US ETP assets is 26.9% 2 $1,350 $1,701 AUM ($B) $1,000 $500 $70 $87 $106 $157 $236 $311 $433 $619 $542 $789 $1,012 $1,061 $ Equity Fixed Income Other Source: BlackRock, Bloomberg, ICI as of 12/31/13. Other category includes alternatives, commodities, currency, target date, asset allocation, and fund of funds Notable statistics 3 US ETP AUM has risen from $70.6 billion in 2000 to $1.70 trillion at the end of US ETPs had ~$190 billion of inflows in 2013 ETFs represented ~25% of U.S. daily equity trading volume in "ETP" (or exchange traded product) as referred to above means any portfolio exposure security that trades intraday on a US exchange. ETPs include exchange traded funds (ETFs) registered with the SEC under the Investment Company Act of 1940 (open-end funds and unit investment trusts or UITs) and certain trusts, commodity pools and exchange traded notes (ETNs) registered with the SEC under the Securities Act of Statistics as of 12/31/13 unless otherwise noted. 2. BlackRock ETP Landscape Industry Highlights December Source: BlackRock ETP Research, Bloomberg, NYSE Arca is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 28

29 Fixed income flows Total U.S. listed ETP AUM ended the year at $1.7 trillion. Fixed income ETPs garnered $12.8 billion or 6.7% of new US assets YTD 2013 US Broad Market ETPs gained the most assets, with net inflows of $12.5 bn 2013 Fixed Income ETP Flows ($bn) Flows ($bn) (10.0) (5.0) Broad Market 12.5 US Government High Yield Investment Grade (6.4) Sovereign (3.3) Municipals (0.8) Corporate 10.8 $12.8 Source: Bloomberg, BlackRock, ICI. Data as of 12/31/2013 "ETP" as referred to above means any portfolio exposure security that trades intraday on a US exchange. ETPs include exchange traded funds (ETFs) registered with the SEC under the Investment Company Act of 1940 (open-end funds and unit investment trusts or UITs) and certain trusts, commodity pools and exchange traded notes (ETNs) registered with the SEC under the Securities Act of is-9518 FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 29

30 ETFs offer access to all sectors of the fixed income market 19 providers now offer 238 fixed income ETFs $300,000 Total AUM ($ millions) $250,000 $200,000 $150,000 $100,000 $50,000 International/EM Active Short Municipals Mortgage Leveraged/Inverse Aggregate Govt/Credit Bank Loans High Yield IG Credit Inflation-Linked Government $ Source: BlackRock and Bloomberg as of 12/31/2013. is-9518 FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 30

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32 ETF application by insurers

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34 Applications of ETFs by Insurers The 2013 Greenwich Associates Report, Institutional Investors Relationship with ETFs Deepens, indicated that 55% of the insurers polled planned to increase their use of ETFs in According to Greenwich, insurance companies employ ETFs primarily within their core investment funds, but are increasingly finding new applications. For example: 33% use ETFs for investing surplus assets 25% use ETFs in annuities ETF Usage by Asset Class 0% 20% 40% 60% 80% 100% Domestic equity 94% International equity 83% Domestic fixed income 78% REITS 50% International fixed income 44% Commodities 39% Source: Greenwich Associates. Report is based on interviews with 18 insurance companies conducted between February and April is-9515 FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 34

35 Applications of ETFs by Insurers Insurance ETF investment strategies General account Funds asset management VA Strategies Reserve assets: Efficient core exposure Targeted asset class exposure Diversified subsidiary portfolios Interim beta Transitions Cash equitization Surplus assets: Equity core Portfolio completion Equity: Multi-asset strategies Tactical / macro strategies Cash equitization Transitions Portfolio completion Fixed Income: Interim beta Active beta strategies Derivatives alternative Delivery vehicle: Single ETF exposure Portfolio of ishares ETFs Wrap accounts Variable insurance trust (VIT) Sub-advised accounts Investment strategy: Single ETF exposure Model portfolios Managed volatility Bespoke strategy is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 35

36 Insurance asset managers are significant holders of ETFs Firm ETF Assets ($mn) MetLife* $8,918 Transamerica* $5,070 Advanced Series Trust** $2,738 John Hancock** $2,306 State Farm* $2,047 PIMCO* $1,769 AXA Equitable** $1,739 TOPS* $1,299 USAA*** $1,230 Lincoln National* $574 MainStay* $519 TIAA-CREF**** $517 Source: Morningstar * As of 12/31/2012 ** As of 2/28/2013 *** As of 11/30/2012 **** As of 1/31/2013 is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 36

37 ETFs for targeted exposures Access hard-to-reach markets ETFs open up new areas where PMs can invest US-listed funds provide diversified, one-trade exposure to non-us corporates or sovereigns ETFs also provide exposure where PMs may not have research coverage such as CMBS or global high yield Exposure High Yield Emerging Markets (USD) Commercial MBS International Developed Emerging Markets (Local Cur.) Emerging Markets Corp. Emerging Markets HY ishares Ticker HYG EMB CMBS IGOV, ISHG LEMB CEMB EMHY Yield CSJ SHY CFT QLTB QLTC HYG QLTA LQD CIU AGG IEF GOVT TIP IEI AGZ TLH CLY TLT High Yield Investment Grade Credit Aggregate Government SHV Duration For illustrative purposes only. Diversification may not protect against market risk or loss of principal. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. ADV as of 9/30/12. Source: BlackRock, Bloomberg is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 37

38 Case study: ETFs for managing smaller subsidiary accounts Challenge: A mid-sized insurance company with $5 billion in assets maintains a segregated general account and four $20-30 million subsidiary portfolios. The company became concerned with the potentially significant cost of trading its subsidiary portfolios and sought to bring operational and cost efficiency to the management process. ishares Solution: The ishares team explained that the challenge facing the client is quite common. Many insurers are required to maintain small sub-portfolios matched to specific lines of business or liabilities. Many insurance companies are utilizing ETFs to provide operational efficiency and portfolio diversification, allowing investment staff to increase focus on their larger general accounts. The ishares team proposed creating portfolios of ETFs that match the asset allocation of the client s general account. The client implemented the ETF portfolio which reduced transaction costs versus trading the legacy bond issues while also providing on-exchange trading simplicity, diversification, and ample liquidity. Source: Blackrock. Case study shown for illustrative purposes only. This is not meant as a guarantee of any future result or experience. This information should not be relied upon as research, investment advice or a recommendation regarding the ishares Funds or any security in particular. is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 38

39 ETFs for interim fixed income exposure Put cash to work quickly Declining bond liquidity makes investing large cash balances more challenging ETFs can provide quick beta exposure to minimize execution risk This can be particularly useful in the high yield bond market where, typically, volatility is high and liquidity is low Cumulative TE (bps) Potential Cumulative Tracking Error 20% Allocation Per Day Trading Days Elapsed 75 bps Vol 100bps Vol 125 bps Vol Then add bonds strategically With an ETF providing short-term beta exposure, a manager can patiently wait for opportunities to add bonds This greater flexibility provides more control over the impact of flows on the portfolio Phase 1: Get invested (T) Cash ishares ETF For illustrative purposes only. Not a recommendation; no guarantee that any strategy will be effective. This illustration is not a complete analysis of every material fact respecting any strategy. Example presented does not take into consideration commissions, tax implications or other transaction costs, which may significantly affect the economic consequences of a given strategy. Source: BlackRock. Chart Scenario: Manager receives large inflow and intends to allocate cash holdings into target bond portfolio over 5 trading days (20% per day) Phase 2: Transition to bonds (T+1-15) ishares ETF Glo bal Ca pita l Mar ket s Cash Bonds Cash Bonds is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 39

40 ishares ETFs custom liquidity solution example Institutional investors are challenged by frequent liquidity constraints and high t-costs A custom liquidity sleeve provides policy exposure with exchange-traded liquidity An allocation to ishares ETFs may be used to rebalance the portfolio and reduce implementation time and t-costs Private Equity, 11% Cash, 3% US Equities, 20% Cash Real Estate, 2% Private Equity IWV Absolute Return, 10% Real Estate US Equities Liquidity Sleeve Absolute Return Real Return, 10% International Fixed Income, 8% US Fixed Income, 13% Emerging Markets Overweight, 4% Non-US Equities, 19% Total Return International Fixed Income US Fixed Income Emerging Markets Overweight Non-US* Equities Fixed income allocation is assumed to be 60% US and 40% international * Due to liquidity advantages, ishares liquidity sleeve uses the market-weighted components of the non-us equity allocation (68% MSCI EAFE, 23% MSCI EM, 8% MSCI Canada) IGOV EMB ishares ETF Name AGG EEM EFA EEM EWC ishares Bond ETF Name IWV Russell 3000 AGG Core Total U.S. Bond Market ETF EFA MSCI EAFE EMB J.P. Morgan USD Emerging Markets EEM MSCI Emerging Markets IGOV International Treasury EWC MSCI Canada is-9624 FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 40

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42 Accounting and Regulatory Overview

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44 ishares NAIC-designated ETFs Ticker ishares Fund Name Fixed Income NAIC Des. AGG ishares Core Total U.S. Bond Market ETF 1 GOVT ishares U.S. Treasury Bond ETF 1 SHV ishares Short Treasury Bond ETF 1 SHY ishares 1-3 Year Treasury Bond ETF 1 IEI ishares 3-7 Year Treasury Bond ETF 1 IEF ishares 7-10 Year Treasury Bond ETF 1 TLH ishares Year Treasury Bond ETF 1 TLT ishares 20+ Year Treasury Bond ETF 1 ISHG ishares 1-3 Year International Treasury Bond ETF 1 IGOV ishares International Treasury Bond ETF 1 AGZ ishares Agency Bond ETF 1 GBF ishares Government/Credit Bond ETF 1 GVI ishares Intermediate Government/Credit Bond ETF 1 ILTB ishares Core Long-Term U.S. Bond ETF 1 CSJ ishares 1-3 Year Credit Bond ETF 1 FLOT ishares Floating Rate Bond ETF 1 QLTA ishares Aaa - A Rated Corporate Bond ETF 1 CMBS ishares CMBS ETF 1 MBB ishares MBS ETF 1 GNMA ishares GNMA Bond ETF 1 MUB ishares National AMT-Free Muni Bond ETF 1 CMF ishares California AMT-Free Muni Bond ETF 1 NYF ishares New York AMT-Free Muni Bond ETF 1 SUB ishares Short-Term National AMT-Free Muni Bond ETF 1 TIP ishares TIPS Bond ETF 1 STIP ishares 0-5 Year TIPS Bond ETF 1 TFLO ishares ishares Treasury Floating Rate Bond ETF 1 ICSH ishares Liquidity Income ETF 1 LQD ishares iboxx $ Investment Grade Corporate Bond ETF 2 SLQD ishares 0-5 Year Investment Grade Corporate Bond ETF 2 QLTB ishares Baa - Ba Rated Corporate Bond ETF 2 Ticker ishares Bond Fund Name Fixed Income NAIC Des. CFT ishares Credit Bond ETF 2 CIU ishares Intermediate Credit Bond ETF 2 CLY ishares 10+ Year Credit Bond ETF 2 ENGN ishares Industrials Bond ETF 2 AMPS ishares Utilities Bond ETF 2 MONY ishares Financials Bond ETF 2 LEMB ishares Emerging Markets Local Currency Bond ETF 2 GTIP ishares Global Inflation-Linked Bond ETF 2 NEAR ishares Short Maturity Bond ETF 2 EMB ishares J.P. Morgan USD Emerging Markets Bond ETF 3 CEMB ishares Emerging Markets Corporate Bond ETF 3 ITIP ishares International Inflation-Linked Bond ETF 3 HYG ishares iboxx $ High Yield Corporate Bond ETF 4 SHYG ishares 0-5 Year High Yield Corporate Bond ETF 4 HYXU ishares Global ex USD High Yield Corporate Bond ETF 4 GHYG ishares Global High Yield Corporate Bond ETF 4 QLTC ishares B - Ca Rated Corporate Bond ETF 4 EMHY ishares Emerging Markets High Yield Bond ETF 4 Ticker isharesbond ETF Name Term Maturity NAIC Des. IBCB isharesbond Mar 2016 Corporate ex-financials Term ETF 1 IBCC isharesbond Mar 2018 Corporate ex-financials Term ETF 1 IBCD isharesbond Mar 2020 Corporate ex-financials Term ETF 1 IBCE isharesbond Mar 2023 Corporate ex-financials Term ETF 1 IBDA isharesbond Mar 2016 Corporate Term ETF 2 IBDB isharesbond Mar 2018 Corporate Term ETF 2 IBDC isharesbond Mar 2020 Corporate Term ETF 2 IBDD isharesbond Mar 2023 Corporate Term ETF 2 NAIC Ticker ishares Fund Name - Equity Des. PFF ishares S&P U.S. Preferred Stock P2 National Association of Insurance Commissioners Securities Valuation Office (SVO) Advanced Rating Service ( ARS ) / Emerging Investment Vehicle ( EIV ) application; Schedule D Treatment, Debt Statutory Classification, NAIC Designation, inclusion on the ETF List in Section 20 of the Appendix of the Purposes and Procedures Manual of the NAIC Securities Valuation Office. The NAIC does not endorse or recommend any securities or products, including ishares ETFs. NAIC designations are issued for specific regulatory purposes and these designations are not equivalent to credit ratings issued by nationally recognized statistical rating organizations. NAIC designations are suitable only for NAIC members. Please refer to the next page for additional information on the NAIC Designation Categories. Preferred stock ETFs assigned a NAIC designation with the valuation indicator P will be subject to different accounting and regulatory treatment than NAIC-designated fixed income ETFs. Please refer to for additional information. 1. Sources: NAIC Designations: NAIC, as of 11/21/12. is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 44

45 Accounting and regulatory overview Insurance companies operating within the US fall under the purview of state governments for both financial statement preparation and regulatory oversight, taking the following into consideration Risk-Based Capital (RBC) requirements: Provides a capital adequacy standard, based on standards set by the National Association of Insurance Commissioners (NAIC) Statutory Accounting Principles (SAP): Followed by all US-domiciled insurance companies for preparation of financial statements submitted to individual state regulatory bodies. SAP standards are set forth by the NAIC and are designed to assess an insurance company s solvency and ability to pay claims in the near-term Generally Accepted Accounting Principles (GAAP): Followed by publicly traded companies for financial statement reporting to the US Securities and Exchange Commission (SEC). The Financial Accounting Standards Board (FASB) sets GAAP in the US 1. Some privately held insurance companies choose to report financial results on both a GAAP and SAP basis. Generally speaking, SAP standards are more conservative than GAAP, as GAAP takes a going-concern approach to financial statement preparation 1. The International Accounting Standards Board (IASB) and FASB have been working together since 2002 to achieve convergence of IFRS and US Generally Accepted Accounting Principles (GAAP). For additional information, please refer to Note that any consideration of the information provided should be performed in conjunction with a full review of the applicable accounting / regulatory rules and the related guidance. Additionally, you should consult your accountant and / or auditor. Source: 2011 Official Annual Statement Instructions, published by the NAIC. The NAIC does not endorse or recommend any securities or products, including ishares ETFs. NAIC designations are issued for specific regulatory purposes and these designations are not equivalent to credit ratings issued by nationally recognized statistical rating organizations. NAIC designations are suitable only for NAIC members. is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 45

46 Impact of NAIC designations: SAP accounting Statutory Accounting Principles (SAP) are set forth by the NAIC and are designed to assess an insurance company s solvency and ability to pay claims in the near-term. Financial Statement Treatment Description Fixed Income ETF with NAIC designation Preferred Stock ETF with NAIC designation Fixed Income ETF with no NAIC designation Equity ETF Valuation Original cost Fair value Market value Market value Unrealized gain / loss recognition Schedule D Treatment N/A Difference between fair value and original cost reflected in surplus Difference between market value and original cost reflected in surplus Difference between market value and original cost reflected in surplus Reporting schedule Part 1 Part 2 Section 1 Part 2 Section 2 Part 2 Section 2 Reporting schedule sub-section Carrying value Long-term Issuer Obligations Industrial and Miscellaneous Mutual Funds Mutual Funds If Asset Valuation Reserve (AVR) 1 is not utilized NAIC 1 2: report at cost NAIC 3 6: report the lower of cost or fair value If AVR is utilized: NAIC 1 5: report at cost NAIC 6: report the lower of cost or fair value If Asset Valuation Reserve (AVR) 1 is not utilized NAIC P1 P2: report at cost NAIC P3 P6: report the lower of cost or fair value If AVR is utilized: NAIC P1 P3: report at cost NAIC P4 P6: report the lower of cost or fair value Market value Book yield Report as zero N/A N/A N/A Maturity Leave blank N/A N/A N/A Par value Report as zero N/A N/A N/A Amount received When paid (Coupon months) Report all distributions received in cash or additional shares Report all distributions received in cash or additional shares Report all distributions received in cash or additional shares Leave blank N/A N/A N/A Market value Report all distributions received in cash or additional shares 1. AVR is a reserve set up by an insurance company against the possibility of credit losses on its investments. It is widely used by life insurance companies but is not available to P&C companies. Note that any consideration of the information provided should be performed in conjunction with a full review of the applicable accounting / regulatory rules and the related guidance. Additionally, you should consult your accountant and / or auditor. Source: 2011 Official Annual Statement Instructions, published by the NAIC. The NAIC does not endorse or recommend any securities or products, including ishares ETFs. NAIC designations are issued for specific regulatory purposes and these designations are not equivalent to credit ratings issued by nationally recognized statistical rating organizations. NAIC designations are suitable only for NAIC members. is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 46

47 ETF classification: GAAP accounting ASC 320 (formerly FAS 115) provides guidance on how to classify investments in debt and equity securities Description ETFs classified as available for sale ETFs classified as trading securities Valuation, per ASC 320 (formerly FAS 115) Fair value Fair value Fair value pricing, per ASC 820 (formerly FAS 157) levels Generally level 1 1 Generally level 1 1 Unrealized gain / loss recognition, per ASC 320 Reported as other comprehensive income ; does not affect income statement Reported as earnings on the income statement Fixed Income ETFs are considered equity instruments under GAAP and therefore can only be classified as trading securities or available for sale. 2 Intent is the key to determine whether to classify an ETF as a trading security or available for sale. Investments that are bought and held principally for the purpose of selling them in the near term (thus held for only a short period of time) shall be classified as trading securities. Trading generally reflects active and frequent buying and selling, and trading securities are generally used with the objective of generating profits on short-term differences in price. If generating profits based on short-term differences in price is not the intent, then investments can be classified as available for sale An ETF will be eligible for level 1 pricing if it has a readily determinable fair value as defined in the ASC Master Glossary. Therefore, under normal circumstances, ETFs are classified as level 1. Source: AICPA Trends and Techniques Publication, All ETFs, including Fixed Income ETFs, do not meet the definition of Debt Security, as defined in the ASC Master Glossary and thus are not eligible for Fixed Income classification. Source: AICPA Trends and Techniques Publication, Information is based on the definition of Security Classifications from ASC 320. Source: AICPA Trends and Techniques Publication, Note that any consideration of the information provided should be performed in conjunction with a full review of the applicable accounting / regulatory rules and the related guidance. Additionally, you should consult your accountant and / or auditor. is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 47

48 Impact of NAIC designations: RBC calculation Risk-Based Capital (RBC) rules specify how much capital an insurance company must have to ensure that it has sufficient capital to withstand contingences. To ensure that there is enough capital to deal with adverse developments, the RBC regime specifies how much capital a company must have to cover asset risks, as well as other business risks ETFs are assigned asset risk based on their applicable classifications. For example, owning $1 of an ETF categorized as common stock means a life insurance company must have $0.30 of capital to back the risk emanating from owning the equities. Owning $1 of an ETF rated as NAIC 1, on the other hand, requires a life insurance company to maintain only $0.004 The RBC calculation is not actually an arithmetic total. Instead, there is a covariance adjustment to reflect that the various classes of risk are uncorrelated Description Fixed Income ETF with NAIC Designation Preferred Stock ETF with NAIC Designation NAIC 1 / P1 P&C 0.3%, Life 0.4% N/A NAIC 2 / P2 P&C 1.0%, Life 1.3% NAIC 3 / P3 P&C 2.0%, Life 4.6% NAIC 4 / P4 P&C 4.5%, Life 10.0% NAIC 5 / P5 P&C 10.0%, Life 23.0% NAIC 6 / P6 P&C 30.0%, Life 30.0% ETF with no NAIC Designation Common stock N/A P&C 15%, Life 30% For further information, please refer to Source: For illustrative purposes only; not a recommendation; no guarantee that any strategy will be effective. The NAIC does not endorse or recommend any securities or products, including ishares ETFs. NAIC designations are issued for specific regulatory purposes and these designations are not equivalent to credit ratings issued by nationally recognized statistical rating organizations. NAIC designations are suitable only for NAIC members. is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 48

49 NAIC Designations Definitions NAIC 1 is assigned to obligations exhibiting the highest quality. Credit risk is at its lowest and the issuer s credit profile is stable. This means that interest, principal or both will be paid in accordance with the contractual agreement and that repayment of principal is well protected. An NAIC 1 obligation should be eligible for the most favorable treatment provided under the NAIC Financial Conditions Framework. NAIC 2 is assigned to obligations of high quality. Credit risk is low but may increase in the intermediate future and the issuer s credit profile is reasonably stable. This means that for the present, the obligation s protective elements suggest a high likelihood that interest, principal or both will be paid in accordance with the contractual agreement, but there are suggestions that an adverse change in circumstances or economic, financial or business conditions will affect the degree of protection and lead to a weakened capacity to pay. An NAIC 2 obligation should be eligible for relatively favorable treatment under the NAIC Financial Conditions Framework. NAIC 3 is assigned to obligations of medium quality. Credit risk is intermediate and the issuer s credit profile has elements of instability. These obligations exhibit speculative elements. This means that the likelihood that interest, principal or both will be paid in accordance with the contractual agreement is reasonable for the present, but an exposure to an adverse change in circumstances or economic, financial or business conditions would create an uncertainty about the issuer s capacity to make timely payments. An NAIC 3 obligation should be eligible for less favorable treatment under the NAIC Financial Conditions Framework. NAIC 4 is assigned to obligations of low quality. Credit risk is high and the issuer s credit profile is volatile. These obligations are highly speculative, but currently the issuer has the capacity to meet its obligations. This means that the likelihood that interest, principal or both will be paid in accordance with the contractual agreement is low and that an adverse change in circumstances or business, financial or economic conditions would accelerate credit risk, leading to a significant impairment in the issuer s capacity to make timely payments. An NAIC 4 obligation should be accorded stringent treatment under the NAIC Financial Conditions Framework. NAIC 5 is assigned to obligations of the lowest credit quality, which are not in or near default. Credit risk is at its highest and credit profile is highly volatile, but currently the issuer has the capacity to meet its obligations. This means that the likelihood that interest, principal or both will be paid in accordance with the contractual agreement is significantly impaired given any adverse business, financial or economic conditions. An NAIC 5 Designation suggests a very high probability of default. An NAIC 5 obligation should incur more stringent treatment under the NAIC Financial Conditions Framework. NAIC 6 is assigned to obligations that are in or near default. This means that payment of interest, principal or both is not being made, or will not be made, in accordance with the contractual agreement. An NAIC 6 obligation should incur the most severe treatment under the NAIC Financial Conditions Framework. is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 49

50 Appendix

51 51

52 ishares ETFs and mutual funds: key differences Criteria ishares ETFs Active Mutual Funds Typical Performance goal Track a benchmark Outperform a benchmark Management Passive Active Performance risks Performance may differ from benchmark. Holdings not altered during rising / falling markets. May not meet performance goal. May underperform due to manager s holdings selection. Buying / selling shares Intraday on exchanges Once per day via fund company Price to buy / sell Current market price, which may differ from NAV End-of-day NAV, less fees Fees Expense ratio + transaction / brokerage costs Expense ratio + any sales loads / redemption fees Tax impact 1 of buyers / sellers Shareholders often only impacted by their own action Holdings disclosure Daily Typically quarterly Shareholders may be impacted by all other shareholders actions 1. Both vehicles are obliged to distribute capital gains to all shareholders. is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 52

53 Structure impacts risks, taxes and tracking error 1940 Act 1933 Act Open-end Fund Unit Investment Trust Grantor Trust Exchange Traded Notes Closed-end Fund Other Listed Vehicles Limited Partnership is

54 Multi-class structure: multiple interests Mutual fund shareholders interact with the same investment pool underlying the ETF share class Direct investor share Institutional share Mutual fund investment pool Advisorsold share ETF share Actions of mutual fund shareholders may create capital gains distributions for ETF shareholders. Additionally, ETF shareholders may pay for potential costs incurred by other share classes Trading ETFs may result in brokerage commissions and/or taxes. Portfolio gains (if any) must be distributed to shareholders. is

55 ETF structure facts: Dedicated vs. multi-class Investment Interest ishares Dedicated ETF Structure Portfolio of stocks and bonds Multi-Class Structure Shares of an investment pool that holds a portfolio of stocks and bonds Costs One expense ratio Fund expenses, including transaction costs from buying and selling securities, are distributed pro rata across all shareholders ETF shareholders pay only for potential costs incurred within the ETF Each class has a unique expense ratio Fund expenses, including transaction costs from buying and selling securities, are distributed pro rata across all shareholders, including potential costs incurred by other classes. Scale may reduce these costs. Shareholders may pay for potential costs incurred by other share classes Tax Efficiency One shareholder s actions do not generate taxable capital gains distributions for other shareholders Redemptions of any class may generate taxable capital gains distributions for other shareholders Liquidity Determined by ETF trading volume and liquidity of underlying stocks and bonds. Can buy and sell throughout the day. ETF Class: Determined by trading volume and liquidity of underlying stocks and bonds. Can buy and sell throughout the day. Mutual Fund Class: Can be bought and sold once day after the fund s net asset value (NAV) is calculated Transparency Daily Typically quarterly Investment comparisons are for illustrative purposes only. Transactions in shares of ETFs will generate tax consequences. ETFs are obliged to distribute portfolio gains to shareholders. is

56 Different types of ETPs Legal Structure Comments Open End Fund Grantor Trust Unit Investment Trust Most common structure; may allow dividend re-investment, securities lending and optimization Structure commonly used for concentrated, specialty exposures that don t meet diversification requirements of open end funds Early ETF structure; does not allow for portfolio optimization, securities lending or dividend re-investment Underlying Assets Comments Index Securities Swaps Futures Physical Assets Notes Securities held either as fully replicating index or optimized proxy Mostly used in levered or inverse funds and exotic exposures; also common in Europe Futures contract or a basket of futures contracts held by the fund, most common for broad commodities Most common in metals ETPs Exchange Traded Notes (ETNs) are debt obligations of the issuer to the holder "ETP" (or exchange traded product) as referred to above means any portfolio exposure security that trades intraday on an exchange. ETPs include exchange traded funds (ETFs) registered with the SEC under the Investment Company Act of 1940 (open-end funds and unit investment trusts or UITs) and certain trusts, commodity pools and exchange traded notes (ETNs) registered with the SEC under the Securities Act of is

57 Glossary Exchange Traded Products Exchange Traded Product (ETP) Exchange Traded Fund (ETF) Exchange Traded Note (ETN) Exchange Traded Commodity (ETC) Exchange Traded Instrument (ETI) Catch-all term for any portfolio exposure product that trades on an Exchange. ETFs, ETCs, ETNs, and ETIs, are all subsets of ETP. The product is regulated as a publicly offered investment fund and can be appropriate for a long term retail investor. Funds whose exposure is achieved via a swap should use the best practices detailed below. Debt securities that may be structured as notes or trusts depending on their domicile. Backed by the credit of its issuer (often an investment bank) which may or may not be collateralized. The extent of regulatory oversight of these products currently varies by region. Limited to products that only hold physical commodities. In the US, these are highly regulated under the Securities Act of A type of ETP that describes any portfolio exposure product traded on an exchange that is not outlined above. The buyer should exercise increased due diligence. ETF Valuation Terms NAV (net asset value) End of day value for the fund Based on previous day closing prices of underlying securities Monitoring value of portfolio, used to assess long-term tracking error IOPV (indicative optimized portfolio value) Intraday, estimated value of the ETF s underlying portfolio baskets Based on recent trades and estimated value of securities Does not include impact of transaction costs and risk estimates to acquire underlying securities Bid/Offer Price Current value of ETF based on all public information Based on best bid/ask spreads Proxy for expected trade value because it includes estimates of transaction costs and risk of acquiring underlying securities is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 57

58 Glossary (cont.) Trading Strategies Agency Trade An order placed with a broker/dealer to execute a trade at cost on behalf of a client. All Day VWAP Limit Order Market Order An order using the ratio of the value traded to the total volume traded over one day. An order to buy and sell an ETF at a particular price or better these orders may or may not be filled. An order that is filled at the best available market price. NAV+ Risk Quote Stop Order An order placed with a broker/dealer to execute at the end of the trading day at NAV plus the fees to create. An order placed with a broker/dealer to execute a trade immediately for a premium on behalf of a client. An order that is processed only if the market reaches a specific price these orders may or may not be filled. Settlement Date The specified date in which the ETF is delivered to the buyer and the payment to the seller. Market Participants Broker/Dealer Individuals or entities that effect transactions of securities for others. Custodian Bank Exchange Specialized bank that is responsible for safeguarding securities and assets on behalf of individuals. A marketplace in which financial instruments are traded. is FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 58

59 Important information regarding ishares ETFs 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. An investment in the Fund(s) is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. When comparing stocks or bonds and ishares Funds, it should be remembered that management fees associated with fund investments, like ishares Funds, are not borne by investors in individual stocks or bonds. The annual management fees of ishares Funds may be substantially less than those of most mutual funds. Buying and selling shares of ishares Funds will result in brokerage commissions, but the savings from lower annual fees can help offset these costs. 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. Securities focusing on a single country, narrowly focused investments (including REIT, preferred stock, factor and floating rate note funds), and investments in smaller companies may be subject to higher volatility. The ishares Minimum Volatility ETFs may experience more than minimum volatility as there is no guarantee that the underlying index's strategy of seeking to lower volatility will be successful. is FOR INSTITUTIONAL USE ONLY--NOT FOR DISTRIBUTION TO THE PUBLIC 59

60 Important information regarding ishares ETFs The ishares Funds are distributed by BlackRock Investments, LLC (together with its affiliates, BlackRock ). The ishares Funds are not sponsored, endorsed, issued, sold or promoted by FTSE International Limited ( FTSE ), India Index Services & Products Limited, JPMorgan Chase & Co., MSCI Inc., Markit Indices Limited, Morningstar, Inc., National Association of Real Estate Investment Trusts ( NAREIT ), Russell Investment Group, S&P Dow Jones Indices LLC or Standard & Poor s, nor are they sponsored, endorsed or issued by Barclays Capital, Inc. None of these companies make any representation regarding the advisability of investing in the Funds. BlackRock is not affiliated with the companies listed above. Neither FTSE nor NAREIT makes any warranty regarding the FTSE NAREIT Residential Plus Capped Index or Industrial/Office Capped Index; all rights vest in NAREIT. All rights in the FTSE Developed Small Cap ex-north America Index vest in FTSE. FTSE is a trademark jointly owned by the London Stock Exchange plc and The Financial Times Limited and is used by FTSE under license BlackRock. All rights reserved. ishares and BLACKROCK are registered trademarks of BlackRock. All other marks are the property of their respective owners. Not FDIC Insured No Bank Guarantee May Lose Value is FOR INSTITUTIONAL USE ONLY--NOT FOR DISTRIBUTION TO THE PUBLIC 60