Fixed income exchange traded funds (ETFs) are transforming the traditionally fragmented and opaque fixed income marketplace. This paper highlights how developments in fixed income ETF trading are providing users with additive liquidity benefits and implementation flexibility.
The first fixed income ETF was launched in 2002 and assets under management for US-listed fixed income ETFs recently surpassed $1T.1 Many consider the financial crisis to be a central catalyst in fixed income ETFs’ growth. Driven by the tighter post-crisis regulatory environment, the shifting market structure of secondary fixed income trading has helped to steer investors toward additional sources of liquidity. These dynamics combined with progress toward electronic trading led many banks to transition from a principal-based dealer to an agency trading model.
Corporate Bond Market Developments
The US corporate bond segment has contributed significantly to overall ETF asset and liquidity growth. This segment of the bond market relies heavily on principal-based market making services. As dealer bond inventories have declined from regulatory initiatives and overall corporate bond issuance has varied dramatically over time, corporate bond ETFs have experienced significant increases in secondary trading. This progress can be attributed to greater focus on inventory management and market making services, integration of fixed income ETFs as a derivative alternative, technological advancements — and a broadening client user base.
Developments in corporate bond ETF trading are evident in the secondary trading profile of the SPDR Bloomberg Barclays High Yield Bond ETF (JNK). As illustrated in Figure 1 JNK’s average annual premium and discount volatility has declined over the last 10+ years. Given these dynamics, JNK’s continuous market price has become a price discovery tool for the underlying constituents.
Source: Bloomberg Finance L.P. As of 06/30/2020.
What Is Additive Liquidity?
The centralized marketplace and price transparency features offered through exchange trading becomes particularly pronounced during periods of market stress. In these environments, traditional fixed income market structure makes it difficult to source liquidity as dealers may be less willing to commit capital — at exactly the time when investors need it most. Amid this uncertainty, investors have gravitated away from attempting to trade many individual corporate bond line items and leaving open orders (with low confidence of execution) on what they cannot sell immediately, and toward the ETF as a dependable source of liquidity.
As illustrated in Figure 2, JNK has experienced significant increases in secondary trading volume during periods of higher relative volatility. The volume spikes can be contextualized by comparing the notional value traded to that of the underlying bonds. The ratio of secondary to primary trading increases as the ETF is used as a preferred vehicle to transfer risk during these periods. JNK secondary market value traded has averaged roughly 9.41% of the underlying high yield bond dollar volumes over the previous four year period, but that percentage historically increases to 10–20% during times of market stress.2