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.