When institutional asset owners, e.g., pensions, endowments and foundations, transition from external managers, more are choosing fixed income exchange traded funds (ETFs) to implement their allocation decisions internally. We are also witnessing a growing use of fixed income ETFs to aid in the transition management process.
US-listed fixed income ETFs have seen their assets double since 2015 to over $1 trillion today.1 And while specific ETF holdings data on institutional asset owners remains limited — despite several US pensions recently providing public filings of fixed income ETFs — we estimate that US pensions held over $5 billion of taxable fixed income ETFs at the end Q1 2020.2 “Pensions are increasingly looking to use credit ETFs and portfolio trading to achieve diversified exposure to credit,” says William Wolcott, Managing Director of Credit Trading at Goldman Sachs.
Rob Melton, Head of SPDR ETF Business Development – US Pensions, Endowments & Foundations, notes that the extreme market volatility in March–April 2020 only accelerated that trend. “With more investors getting comfortable using ETFs as an essential portfolio management tool, we’ll continue to see ETFs used in more innovative ways,” he says.
Based on their unique structural features, ETFs can help facilitate transition management – defined as the transfer of assets in a separately managed account (SMA) from an existing (terminated) manager to either internal management or to another external manager.
Many of the innovative uses leverage ETFs’ benefits – low cost, high liquidity and improved transparency – that stem from their creation and redemption process. Differentiating the ETF relative to other investment vehicles, “in-kind” creation and redemption is a process whereby ETF shares are exchanged for some or all of the fund’s underlying basket of securities. It was designed to allow designated authorized participants (APs), which are US-registered self-clearing broker-dealers, to engage directly with ETF managers. Working on behalf of institutional investors, APs can exchange bonds with an ETF issuer directly, whereas buy-side firms cannot.
“Creation/redemption can be thought of as the backbone that allows APs and other market makers to provide liquidity in an ETF,” explains Melton. “The process also facilitates their ability to maintain a close linkage between the price of the ETF trading in the secondary market and the NAV of the fund, which is calculated based on the prices of underlying constituents.”
Fixed Income ETFs and Transition Management
Increasingly recognized as offering fungibility with cash bonds, using fixed income ETFs for transition management enables investors to:
Maintain a Continuous Exposure to the Benchmark Index: The process to liquidate individual bonds in order to purchase a more liquid macro instrument can introduce potential market risk and tracking error.
Transaction Cost Savings: Bid-ask spreads for institutional-size ETF trades have historically been significantly lower than indicated spreads for underlying fixed income securities.3
Improve the Strategy’s Liquidity Profile: ETF trading on exchange provides a consolidated venue of observable liquidity. ETFs’ robust secondary market allows investors to tap into market liquidity more easily than they can with single-CUSIP bond holdings.
Increase Efficiency: ETFs provide operational ease by consolidating many line items to one to facilitate trading relative to buying individual bonds in the OTC market.
Illustrative Transition Management Case Study
Client Need: Pension A decides to internalize management of an intermediate investment-grade corporate bond portfolio that is currently being handled by an external manager.
Hurdle to Overcome: Transitioning from an external manager can take time and leave the pension without market exposure to the specified benchmark during the transition phase.
Prior to the widespread implementation of ETFs, liquidating a sleeve of individual bonds to purchase a more liquid macro instrument was an onerous task, requiring multiple, sometimes staggered, steps: selling the bonds and then purchasing the macro exposure like a credit default swap (CDX) or a total return swap (TRS). These two separate transactions would require investors to:
Sell bonds on the bid side of the market (for which they had paid the offer side), thereby realizing bid-ask costs of ~20-30 bps
Buy macro exposure, paying the offer side, for a position likely to be marked on the bid side, which may cost another 5-15 bps
Note, there is potential for market risk should the two transactions not be aligned, timed, or linked with the same broker.
Solution: Pension A chooses to implement the transition through an investment-grade ETF in order to maintain market exposure and reduce the cost of the transition.
The versatility and unique ability to exchange shares for bonds and vice versa introduces a variety of new use cases for the ETF. Given the dealer-controlled nature of corporate bond trading, the buy-side is beholden to a more fragmented market when transacting in bonds.
Pre-trade Considerations: While an ETF can enhance a bond portfolio’s overall liquidity profile, managers should consider the following questions:
Is there an ETF that matches my portfolio from an exposure perspective?
Are my holdings too concentrated in sector, maturity, ratings and ticker cohorts?
Can my order management system (OMS), portfolio management, and risk systems handle an equity wrapper in a fixed income portfolio?
If I choose to sell the ETF, am I set up for equity trading capabilities and relationships?
Am I set up to lend out my ETF to earn additional income?
Am I able to book a large amount of bond tickets within the time frame required?
Note: If the answer is “No” to any of these questions, the SPDR Capital Markets desk can propose easy-to-implement solutions.
Implementation: We can use a portfolio of 1–10-year USD Investment Grade Corporates, along with a comparable fund, the SPDR Portfolio Intermediate Term Corporate Bond ETF (SPIB), which seeks to track the Bloomberg Barclays Intermediate Corporate Index.
Given that ETFs may be viewed as being fungible with eligible underlying bonds, converting a portion of a bond portfolio to an ETF involves significantly lower transaction costs.
Counterparties: Use of fixed income ETFs for the purposes of transition management requires an AP to work on behalf of an investor. Sitting between the outside manager and Pension A, the AP (the only counterparty that is legally able to create/redeem ETFs) takes these steps, working alongside the ETF issuer:
1. On the trade date, the basket of securities will be sold by the external manager to the AP.
a. This step may require negotiation between the two parties, based on the fit of the underlying basket relative to the benchmark index of the ETF.
b. If the basket that the investor wants to deliver is not fully compatible or representative of the index, the AP can offer to supplement or complete the list of securities (known as a “completion trade”). The AP will fill in any gaps by sourcing the necessary bonds (either from their own inventory or other avenues) and charge the external manager accordingly for this incremental work, as well as for inherent transaction costs. This process helps to align the underlying baskets that will be used for delivery to the ETF issuer with the ETF exposures.
2. The AP performs an “in-kind” creation with the ETF issuer, delivering underlying bonds as well as a small cash portion (plug) and receiving shares of the ETF on the settlement date (T+2).
a. The transactions are executed using the Net Asset Value (NAV) (typically bid-side pricing) of the underlying bonds and using the official NAV of the ETF.
b. The number of bonds delivered to the ETF issuer is typically a smaller subset of the underlying index. This number varies depending on the size of the overall transaction as well as the composition of the basket and the risk exposures of the fund.
3. Upon receipt of the ETF, the AP will deliver shares of the ETF to Pension A in exchange for cash.
The method in which commissions are charged for the transaction may vary slightly amongst the AP community, but it will typically be reflected in slight adjustments of the bond prices or ETF price.
Figure 2 highlights the Net Asset Value (NAV) calculation from the AP to the ETF issuer for a targeted amount of $100 million notional. For the sake of simplicity, this example uses 10 eligible bonds held in the SPDR Portfolio Intermediate Term Corporate Bond ETF (SPIB). However, an actual transaction would typically require a larger minimum number of bonds (i.e., 50-100 securities).
Figure 2: Trade/Basketing Example
Market Value of Create
Create Size (rounded)
Accrued Interest (t+2)
Total Market Value
CVS 4.3 03/25/28
TMUS 3 7/8 04/15/30
BAC 3.149 12/20/28
AAPL 2.4 05/03/23
BA 5.15 05/03/23
PCG 4.55 07/01/30
WMT 3.7 06/26/28
DD 4.205 11/15/23
RDSALN 3 1/4 05/11/25
Source: State Street Global Advisors, illustrative example.
Importantly, as shown above, the individual prices for bonds (and accordingly, the ETF’s NAV), are struck after the transaction takes place. As a result, the cash plug has to be adjusted ex-post for a perfect reconciliation. The cost of this transaction for the AP vis-a-vis the ETF issuer is minimal: it includes booking fees and a nominal creation fee (typically $250–$500 as a flat fee). Incremental fees the AP would charge Pension A may include the cost of rebalancing a portfolio from the initial external manager, plus a commission.
The fixed income ETF becomes a tool to allow for an efficient transfer of assets from one counterparty to another. This process benefits from the transparent pricing of securities based on the Net Asset Value of the fund. The expectation is that the overall sum of fees would be significantly lower than the transaction costs mentioned in Figure 1, therefore minimizing costs for Pension A.
Broad ETF Usage to Drive Innovation
In addition to using fixed income ETFs as a transition management tool, more investors are using ETFs to alleviate broader operational burdens, such as handling scores of individual CUSIPs. For example, Darryl Trunnel, Senior Fixed Income Portfolio Manager at Principal Global Investors, recently turned to fixed income ETFs to help manage a collection of more than 300 individual bond positions.
“We had taken in a significant number of small line items across multiple portfolios and needed to adjust some of the positions to align with a broad corporate index exposure,” he explains. “We were concerned about the cost of execution as well as the timing of managing these positions, and we also wanted to be sure to maintain a broad index exposure during the process.”
“This allowed us to better align our corporate credit exposure across three different funds,” he notes.
Investors’ increasing reliance on US fixed income ETFs was particularly evident during the recent bout of volatility in March 2020. When bond market liquidity was constrained, we saw record volumes in fixed income ETFs.
In fact, as shown in Figure 3, trading volumes of investment-grade and high yield corporate bond ETFs increased substantially as a percentage of cash bond trading during March 2020 compared with the preceding and subsequent time periods.
Figure 3: Trading Volume of Corporate Bond ETFs in Percentage of Cash Bond Trading
Jan 2020 (%)
Feb 2020 (%)
Mar 2020 (%)
Apr 2020 (%)
May 2020 (%)
Source: State Street Global Advisors, Bloomberg Finance Ltd as of May 31, 2020.
As Andreas Roy, a fixed income trader at Jane Street, highlights, in times of volatility, it is more important — and often more difficult — for portfolio managers to transfer risk efficiently. “ETFs have been an effective solution by allowing PMs to gain diversified exposure with minimal market impact. They also serve as a tool for PMs to quickly respond to outflows and inflows and transition between different exposures,” he explains.
When it is difficult to trade bonds and face dealers in stressed markets, market participants can rely on the pricing transparency and centralization of liquidity, which allows fixed income ETFs to act as a liquidity valve.
Figure 4 highlights some of the bid-ask spread differences between individual cash bonds and a fixed income ETF for institutional-size trades. The average ETF bid-ask spread across fixed income sectors such as high yield, intermediate and long-term corporates and convertibles averaged 54% less than the respective cash bond market.
*“Institutional size” defined as $50 M for JNK, SJNK, SPIB, SPLB and CWB. As represented by the Barclays Liquidity Cost Score (LCS) metric for the respective index - Bloomberg Barclays High Yield Very Liquid Index, Bloomberg Barclays U.S. High Yield 350mn Cash Pay 0-5 Yr 2% Capped Index, Bloomberg Barclays Intermediate U.S. Corporate Index, Bloomberg Barclays Long U.S. Corporate Index, Bloomberg Barclays U.S. Convertibles Liquid Bond Index. There can be no assurance that a liquid market will be maintained for ETF shares. As of 12/31/2019.
Fixed income ETFs have become a dynamic tool for institutional fixed income trading and portfolio management. Today, whether you seek broad index, targeted subsector or active exposures, more than 400 US-listed fixed income ETFs offer diversification across numerous bonds with a single trade. They also provide access to segments of the fixed income market in which purchasing individual bonds can be prohibitively expensive and time consuming.
As the usage of ETFs continues to increase and technology advances, institutional investors are taking advantage of the ETF’s unique features and flexibility to implement a variety of innovative solutions. This includes using ETFs for transition management. As more investors choose ETFs to manage various risks and portfolio exposures, we believe innovative uses for fixed income ETFs will continue to increase.
1 Source: Morningstar, as of 8/31/2020.
2 Source: State Street Global Advisors estimates, as of 6/30/2020.
3 Source: Bloomberg, as of 12/31/2019. As represented by the Barclays Liquidity Cost Score (LCS) metric for the respective index vs. comparable ETF. There can be no assurance that a liquid market will be maintained for ETF shares. See Figure 4
AP, or Authorized Participant A US-registered and self-clearing broker-dealer who meets certain criteria and signs a participant agreement with a particular ETF sponsor or distributor to become an “authorized participant” of the fund. APs are often associated with large and influential investment banks and are scrutinized for their integrity and operational competence, as they are the only parties who transact directly with an ETF.
Basis Point (bp) A unit of measure for interest rates, investment performance, pricing of investment services and other percentages in finance. One basis point is equal to one-hundredth of 1 percent, or 0.01%.
Bloomberg Barclays High Yield Very Liquid Index The Barclays High Yield Very Liquid Index is designed to measure the performance of publicly issued U.S. dollar-denominated high yield corporate bonds with above-average liquidity.
Bloomberg Barclays Intermediate U.S. Corporate Index A benchmark designed to measure the performance of U.S. corporate bonds that have a maturity of greater than or equal to one year and less than 10 years.
Bloomberg Barclays Long U.S. Corporate Index A benchmark designed to measure the performance of U.S. corporate bonds that have a maturity of greater than or equal to 10 years.
Bloomberg Barclays U.S. Convertibles Liquid Bond Index An index designed to represent the market of U.S. convertible securities, such as convertible bonds and convertible preferred stock. Convertible bonds are bonds that can be exchanged, at the option of the holder or issuer, for a specific number of shares of the issuer’s equity securities. Convertible preferred stock is preferred stock that includes an option for the holder to convert to common stock.
Bloomberg Barclays U.S. High Yield 350mn Cash Pay 0-5 Yr 2% Capped Index A fixed-income benchmark that seeks to measure the performance of short-term, publicly issued U.S. dollar-denominated high yield corporate bonds. High yield securities are generally rated below investment grade and are commonly referred to as “junk” bonds.
Liquidity The ability to quickly buy or sell an investment in the market without impacting its price. Trading volume is a primary determinant of liquidity.
Net Asset Value, or NAV The price of a share determined by the total value of the securities in the underlying portfolio, less any liabilities.
Over-The-Counter, or OTC A term in financial markets used to describe transactions that occur away from any listed exchanges between individuals or involving dealer networks, whether in stock, bond, currency or derivatives markets.
Spread, or Bid-Ask Spread 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.
Volatility The tendency of a market index or security to jump around in price. Volatility is typically expressed as the annualized standard deviation of returns. In modern portfolio theory, securities with higher volatility are generally seen as riskier due to higher potential losses.
The views expressed in this material are the views of State Street Global Advisors through the period ended September 30, 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.
ETFs trade like stocks, are subject to investment risk, fluctuate in market value and may trade at prices above or below the ETFs net asset value. Brokerage commissions and ETF expenses will reduce returns.
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