Since their introduction in 2002, US-listed fixed income exchange traded funds (ETFs) have seen assets grow at an annualized rate of about 38%.1 In early August 2020, US fixed income ETF assets crossed the $1T mark.2 This steady growth has created a centralized and transparent fixed income marketplace. By 2025, State Street SPDR projects global fixed income ETF assets to surpass the $3T mark.
ETFs were created to help stabilize markets and improve liquidity during periods of market turbulence and it’s no surprise the product structure has been particularly important in fixed income markets. When volatility strikes, fixed income dealers often become less willing or able to commit capital, making it more difficult to source liquidity through traditional market structures — exactly when investors need liquidity most.
During the Q1 2020 pandemic-induced liquidity crunch in bond markets, fixed income ETFs continued to perform as expected. As shown below, although the bid/ask spread of underlying investment-grade bonds significantly widened, fixed income ETF spreads remained comparatively tighter, offering investors the ability to perform price discovery on exchange as the underlying bond market became increasingly constrained.
SPDR Portfolio Intermediate Corporate Bond ETF (SPIB)
SPDR Portfolio Intermediate Corporate Bond ETF
2020 YTD as of Feb 21
Feb 24- Mar 24, 2020
SPIB ETF Avg Daily Turnover
SPIB ETF Spread
SPIB Basket Spread
Source: ITG; Bloomberg Finance L.P., as of March 24, 2020. ENAV is a Virtu product powered by Composite+ or CP+ from MarketAxess, which is an AI-powered algorithmic pricing engine for corporate bonds. Spread data is based on daily medians.
ETFs’ role as buffers and sources of liquidity in stressed markets was further bolstered when, in March, the Federal Reserve announced its intent to purchase fixed income ETFs through the Secondary Market Corporate Credit Facility (SMCCF) Program to support and add liquidity to the underlying bond markets.
This environment has institutional investors increasingly turning to fixed income ETFs to solve their own portfolio challenges. After the Fed’s announcement, fixed income ETF assets grew nearly $200B from the end of March to December 31, 2020.3 During that time, we saw an increase in the number and size of institutional accounts. While the institutional segment — which accounts for roughly 16% of the fixed income ETF market — grew at a 39% CAGR from the end of 2019 through September 2020, its CAGR from March to September 2020 reached 69% based on an analysis of the latest holdings data available.4
Institutions have observed how fixed income ETFs passed this latest volatility test and better understand what happens structurally when ETFs are used as price discovery tools. The persistent and sizable inflows into fixed income ETFs since the onset of the pandemic reflect institutional investors’ confidence in the fixed income ETF structure.
Today, more than 400 US-listed fixed income ETFs offer investors diversification across numerous bonds with a single trade.5 They also provide access to segments of the fixed income market in which purchasing individual bonds can be prohibitively expensive and time consuming or operationally cumbersome. Potentially more attractive than mutual funds or individual bonds, fixed income ETFs offer investors:
Asset owners have a different trading profile than hedge funds and some asset managers. Asset owners are likely to trade less frequently, but their allocation shifts may result in very large trades. With dealers committing less capital to individual bond trades, shifting a fixed income portfolio across potentially hundreds of CUSIPS can result in increased execution costs and greater time for order completion.
ETFs bring together bond baskets for efficient trading on exchange with support from two “levels” of liquidity — the primary and secondary markets. The primary market refers to the creation or redemption of ETF shares. Authorized Participants (APs), large institutional traders authorized by the ETF sponsor, transact with the fund directly in the primary market. The secondary market is where most investors trade ETFs on a stock exchange or other listed venue. Additionally, because ETFs tends to have multiple bond dealers providing two-way bids and offers, a more transparent and competitive execution venue may help further reduce overall transaction costs.
Source: Bloomberg Portfolio Liquidity Analytics, Jane Street Capital as of 01/11/2021. *Institutional Size defined as $50mm for SJNK, JNK, SPIB, SPLB, CWB. **As represented by the basket spread for each respective index. There can be no assurance that a liquid market will be maintained for ETF shares.
Potential for Improved Liquidity
ETFs’ robust secondary market allows investors to tap into market liquidity more easily than they can with single-CUSIP bond holdings. This enables them to reallocate portfolios quickly across asset classes or meet investor redemptions by selling an ETF position into the market without having to sell single-CUSIP bonds.
For example, since 2004, the size of the US investment-grade bond market has grown while turnover has declined. The number of Trade Reporting and Compliance Engine (TRACE) traded CUSIPs in US Investment Grade has grown from approximately 10,000 in Q4 2004 to nearly 19,000 in November 2020.6 In addition to the number of individual CUSIPs in the market, overall investment-grade debt during that same time period has grown over four-fold, from $2.2T to $9.1T.7
While the market has grown in size, turnover for investment grade has decreased roughly 30% from Q1 2006 through November 2020.8 The result has been a bond market that is larger in size, but presents less trading opportunities for investors.
Source: MarketAxess, as of November 1, 2020.
Fixed income ETFs have helped to fill a liquidity gap in the fixed income markets by providing transparent and competitive pricing of bonds, allowing investors to gain access to broad swaths of the fixed income markets.
Increased Diversification and Transparency
ETFs may own many different credits across a wide array of industries and issuers. For example, the SPDR® Portfolio Intermediate Term Corporate Bond ETF (ticker: SPIB) has over 4,000 individual bonds in its portfolio holdings.9 Because ETFs provide daily transparency of holdings, investors can see individual CUSIPs on the ETF sponsor website, allowing them to deconstruct the ETF and analyze its individual components.
In addition, analytics platforms such as Bloomberg provide portfolio analysis through the “PORT” function. The “YAS” function on Bloomberg allows investors to evaluate a fixed income ETF in more “bond like” terms. For example, typing in “SPIB US <Equity> YAS <GO>” on Blomberg provides investors with a view into some of the fixed income risk metrics of SPIB, such as duration, convexity and spread-to-benchmark.
Using ETFs as portfolio building blocks enables institutional investors to fine-tune interest rate risk by adjusting duration to align with their market views and risk tolerance. In addition, investment-grade credit, senior loans, and high-yield bond ETFs provide investors opportunities to manage a portfolio’s credit risk by adjusting both security type and/or credit quality.
This flexibility makes it easier to build and adjust portfolios to match strategic goals and take advantage of tactical opportunities as they arise. Institutional investors use fixed income ETFs to:
While the underlying bond market is highly fragmented, based on dealer-controlled pricing, and has little transparency, fixed income ETF liquidity is highly observable, given the use of an exchange as part of its market structure.
With fixed income ETFs, the exposure from an entire sector, index exposure or asset class can be added or reduced in one quick trade, whereas trading the individual constituents for that exposure could involve a considerable amount of time and cost, given the complexities of single-CUSIP execution.
ETFs provide more transactional flexibility since the secondary market offers opportunities to liquidate positions at a transparent price, at any time, without touching the primary market. The existence of a secondary market for fixed income ETFs allows shares to change hands between buyers and sellers at a significantly tighter bid/ask spread — without the need to transact in the underlying securities. On the other hand, mutual fund structures operate on a primary market basis, where the selling of shares often directly results in the trading of underlying securities. Mutual funds can be redeemed only at market close, putting mutual fund managers at a disadvantage if they need to fund redemption requests while the primary market is depressed.
In addition, the ETF structure can provide greater operational flexibility than mutual funds when it comes to managing portfolio turnover, cash availability and redemptions. Mutual fund shares settle one day after their trade date (T+1). That requirement creates a mismatch in liquidity with a fund’s underlying bonds, which typically settle two days after the trade date (T+2). The need to pay out redemptions a day before receiving proceeds from bond sales can pose challenges, especially in the event of large redemptions and/or constrained market liquidity. ETFs, on the other hand, settle at T+2 on both primary and secondary markets with in-kind transfers between APs — rather than security sales — funding the redemption, which can add to ETFs’ tax efficiency relative to mutual fund holdings.
As more institutional investors discover the benefits of fixed income ETFs, the number of choices in the category and their applications as a portfolio management tool are likely to expand. Working with an ETF sponsor like State Street SPDR can be invaluable.
For example, dedicated SPDR fixed income and capital markets teams have robust relationships with liquidity providers and can help with:
An ETF sponsor can also help develop an appropriate due diligence framework to help choose the right ETF. Key considerations and questions include:
|Index/Fund:||Does the index/fund align with my portfolio objectives?|
|Fund Provider:||Does the firm have a solid reputation in the ETF marketplace?|
|Structure:||Does the fund’s structure help mitigate portfolio risks and promote liquidity?|
|Liquidity:||Can I trade when I want at the desired size?|
Does the fund exhibit tracking error to the benchmark it represents?
|Performance:||Are the fund’s historic return and risk statistics in line with its stated objectives and benchmark?|
|Transparency:||What is the level of portfolio holdings transparency?|
|Total Cost:||Have I considered the tradeoffs between trading and holding costs? In evaluating total cost, investors should look beyond the management fee to consider tracking return differences as well as trading costs.|
In addition, a discussion with an ETF sponsor can help evaluate execution priorities and trade considerations when it comes time to implement a fixed income ETF trade.
|Timing:||What is the level of urgency? Is there a specific timeframe for execution or a specific benchmark target?|
|Size:||How does the order size compare with the ETF’s historical averages and what is the size of the trade relative to the underlying index?|
|Execution:||How might this order be executed from a counterparty? Will the dealer, in turn, create shares of the underlying ETF via the Primary Market? Is the market trading in an orderly fashion as measured by bid/ask spreads, average daily volumes, overall price movements and premiums/discounts to NAV?|
Fixed income ETFs’ combination of low costs, liquidity, range of choice and transparency allows institutional investors to manage portfolios with flexibility and precision. The surge in fixed income ETF trading volumes in March 2020 — when trading volumes of investment-grade and high yield corporate bond ETFs increased substantially as a percentage of cash bond trading compared with the preceding and subsequent time periods — is further evidence that institutional investors gravitate toward ETFs as liquidity vehicles when individual bond liquidity becomes stretched.
As their benefits and uses continue to be more broadly explored and understood, fixed income ETFs will likely continue to increase in number and variety, supporting new applications that we expect will push global fixed income ETF assets to surpass $3T by 2025.
1Morningstar, July 2002 to December 2020.
2Bloomberg Finance L.P., as of December 31, 2020.
3Bloomberg Finance L.P., from March 31, 2020 to December 31, 2020.
4Broadridge, SSGA, as of September 30, 2020.
5Morningstar Direct, as of December 31, 2020.
6MarketAxess, as of November 1, 2020.
7Bloomberg, as of November 31, 2020.
8MarketAxess, as of November 1, 2020.
9State Street Global Advisors, as of December 29, 2020.
Distinct groups of investments that have similar characteristics and past performance, such as stocks, bonds, cash, real estate and commodities. Asset classes can also be further segmented, such as emerging market equities in the case of stocks and US corporate bonds in the case of fixed income.
The difference between the highest price a buyer is willing to pay for an asset and the lowest price the seller will accept to sell. Bid-ask spreads are a key measure of the liquidity of an asset or security.
Compound Annual Growth Rate, or CAGR
An imaginary number that describes the rate at which an investment would have grown if it had grown at a steady rate. CAGR is not the actual return, but is a method of smoothing out returns for analytical purposes.
A strategy of combining a broad mix of investments and asset class to potentially limit risk, although diversification does not guarantee protecting against a loss in falling markets.
A type of investing, usually involving bills, notes or bonds, for which real return rates or periodic income is received at regular intervals and at reasonably predictable levels. Fixed income can also refer to a budgeting style that is based on fixed pension payments.
The ability to quickly buy or sell an investment in the market without impacting its price. Trading volume is a primary determinant of liquidity.
The market where Authorized Participants (APs) create and redeem ETF shares in-kind, typically in blocks of 50,000 shares, which are known as creation units.
The market in which ETF shares or common shares of public companies that currently exist are traded on exchanges between investors.
A financial instrument representing ownership positions in a publicly-traded stocks, corporation- and government-issued bonds, or rights to potential ownership as options represent. A security is a fungible, negotiable financial instrument that represents some type of financial value. The party that issues the security is called the issuer.
The views expressed in this material are the views of State Street Global Advisors through the period ended December 31, 2020, and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
Bonds generally present less short-term risk and volatility than stocks but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Investing in high yield fixed income securities, otherwise known as "junk bonds," is considered speculative and involves greater risk of loss of principal and interest than investing in investment-grade fixed income securities. These lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
Issuers of convertible securities may not be as financially strong as those issuing securities with higher credit ratings and may be more vulnerable to changes in the economy. Other risks associated with convertible bond investments include: Call risk, which is the risk that bond issuers may repay securities with higher coupon or interest rates before the security's maturity date; liquidity risk, which is the risk that certain types of investments may not be possible to sell the investment at any particular time or at an acceptable price; and investments in derivatives, which can be more sensitive to sudden fluctuations in interest rates or market prices, potential illiquidity of the markets, as well as potential loss of principal.
Investing involves risk, including the risk of loss of principal.