Challenges in the bond market and the benefits of fixed income ETFs – Sponsored by iShares and IHS Markit
Natacha Blackman, iShares fixed Income Product Strategy, BlackRock and Smadar Shulman, Managing Director, Indices, IHS Markit share their views on the bond market and the advantages of fixed income ETFs.
Institutional investors looking to allocate to fixed income and navigate challenging bond markets are increasingly using UCITS fixed income ETFs, says BlackRock’s Blackman.
“As the structure of the European bond market continues to evolve in response to changes in regulation, technological advances and shifting investor behaviour, the influence of UCITS fixed income ETFs within the bond market ecosystem is growing,” Blackman says.
“With the challenges they face investing in fixed income markets, we’ve seen investors make use of a broader toolkit when managing their portfolios, using a combination of both funded and unfunded instruments to manage risk. ETFs have become part of this toolkit, as they offer investors certainty of execution, immediacy and price discovery, even in fast moving markets.”
Blackman recalls that BlackRock witnessed this during the Covid-19 selloff in 2020. “From late February through late March 2020, iShares UCITS fixed income ETF trading surged to USD17.5 billion per week on average, more than twice the 2019 weekly average of USD7.8 billion, she says. “While we have previously seen increased trading during fast moving markets, what we saw in March was unprecedented, in just how much investors were using fixed income ETFs to access and transfer risk.”
She also notes that with the development of FI ETF options as well as the repo and unit lending markets for ETFs, investors also increasingly have the ability to trade ETFs from both the long and short side and has helped to enhance liquidity further.
“As well as liquidity, the diversification and transparency offered by ETFs have helped ETFs to become central to valuation, portfolio construction and risk management for institutional investors,” Blackman concludes.
IHS Markit’s Shulman comments that one key challenge for fixed income markets experienced last year in the March market dislocation was the pricing of the bonds underlying various market instruments.
“In terms of transparency, indexing through ETFs offered the price discovery that was needed,” she says, quoting the Bank of England, Interim Financial Stability Report in May 2020 on prices on bond ETFs, which says: “…appear to have provided information about future changes in underlying asset markets, offering evidence that they incorporated new information more rapidly than the net asset values (NAV) of assets held with their, and equivalent, funds.”
“As an index provider we also saw a very notable increase in the trading of unfunded index products to manage market disruption as well,” Shulman says. “On the pure credit risk side, CDX and iTraxx indices (including swaptions) saw ~USD30 trillion in notional traded in 2020, and at the height of the crisis volumes were over 50 per cent year-on-year increase, which can be partly attributed to their ability to withstand large trading sizes. Similarly, volumes on the iBoxx Standardized Total Return Swaps (TRS) were also very high during this period. From a hedging perspective, we saw these tools being used to manage exposure into cash bonds, or into a different mix of HY, IG and other asset classes without altering the underlying portfolios too much.”
Shulman observes that the growth and depth of liquidity in tradable credit index products continues to benefit the developing fixed income ecosystem. “Additionally, ETFs remain robust and more broadly, the portfolio ecosystem has evolved i.e. portfolio trading is now heavily linked to the create and redeem process of ETFs.
“These all bring standardisation, price transparency and trade efficiency to an otherwise often opaque and fragmented fixed income market. In 2020, we saw how in times of stress, these instruments performed as intended, providing continuous liquid access to key exposures which allowed investment managers to manage their exposures in an efficient manner.”
Blackman comments that the market turmoil driven by the COVID-19 crisis has led to a significant transformation in the institutional investor adoption of fixed income ETFs.
“Institutions are using fixed income ETFs to firstly build liquidity sleeves around their core portfolio, secondly use fixed income ETFs to quickly and efficiently invest cash flows, thirdly to use fixed income ETFs alongside derivatives and finally there is an increase in the evolution in how broker-dealers use fixed income ETFs,” Blackman says.
Sustainable investment and indexing has seen enormous growth over the past few years. “Environmental, social and governance (ESG) and sustainable investing continues to gather strong momentum,” Blackman says. “In 2020, AUM for ESG fixed income ETFs globally has grown to USD23 billion - more than quadruple AUM in 2018.
“As at H1 2021, AUM had grown further to USD37 billion. While the regulations around sustainable investing are still evolving in Europe, the trend towards greater ESG awareness and adoption is clear. According to Greenwich Associates research, nearly 60 per cent of European institutional investors polled expect to have more than 50 per cent of their assets managed with an ESG criteria within five years.”
Blackman comments that what used to be an institutional trend across northern Europe is reaching a much broader investor base geographically and across investor types, including institutional asset managers, asset owners and wealth managers.
“Furthermore, ESG data providers are expanding their coverage universe and improving the quality of their metrics, working closely with index providers to deliver investable ESG versions of established broad market indices,” she says.
“Fixed income ETFs can be used by investors to integrate ESG considerations into their portfolios. Indeed, many of the core exposures where European investors are most active already exist in a sustainable format — and AUM are growing quickly. For example, the largest iShares fixed income ESG UCITS fixed income ETF in the market today has over USD 2.8 billion in assets.
Shulman notes that there is a large variation of how ESG is implemented. “The available ESG product suites - whether through basic screening of companies engaged in controversial practices, applying minimum standards based on ESG ratings/scores in combination (sometimes referred to ‘best in class’), or applying weight tilts based on ESG related scoring, potentially optimising to keep certain sector risk profiles, or thematic products such as climate or carbon-related and green social & sustainability bonds,” Shulman says. “We’ve launched several products to meet the varying needs of clients, including iBoxx MSCI ESG Ultrashort ‘best in class’ range, as well as IHS Markit Global Carbon Index tracking the price of carbon credits and iBoxx Global Green, Social, & Sustainability bonds index.
“When we think about sustainable fixed income indices, one of the considerations for fixed income specifically is managing the ESG data itself. ESG data is often based on listed equity issuers, so ‘equity like data’ whereas bonds can be issued under different entities along the corporate hierarchy, including private entities. Having a robust framework in place that maps and handles exceptions is crucial, and we’ve spent a lot of effort on this aspect to enable adaptable integration of ESG factors into our fixed income indices.”
Shulman comments that alongside data considerations is index design. “Investors are looking for a transparent, rules- based approach to sustainable investing,” she says. “So, designing products that are liquid and replicable which fit the underlying market they are trying to track is important. Something we do for non- ESG indices but is also important when incorporating ESG criteria. Investors are looking at different design features depending on their objectives.
“ESG data is continuously evolving, with more data points being captured as company reporting evolves, which in turn will also shape continued product design across asset classes.”
Liquidity provision lies at the heart of the ETF’s efficiency. Asked how should institutional investors think about sustainable fixed income ETFs in terms of liquidity, Blackman says: “Many ESG ETFs benefit from the liquidity of their non-ESG sister funds due to the considerable overlap between the benchmarks they track.
“This overlap can reduce trading costs for investors looking to either switch from the non-ESG into the ESG version or AP’s create/redeem. Over time, as ESG adoption increases, ESG ETFs are expected to overtake the non-ESG ETFs in terms of AUM and liquidity metrics, becoming the new ‘flagship’ funds.”
Blackman believes that fixed income ETFs have seen increased modernisation over recent years. “Much of the early investment into electronification came from ETF market makers (Authorised Participants, or APs), who sought to gain efficiencies in their own workflow,” Blackman says. “For example, growing demand for broker-dealers and APs to rapidly price and trade portfolios of bonds to facilitate fixed income ETF creation and redemption led to the rise of algorithmic bond pricing, and accelerated the adoption of electronic trading and alternative bond trading architecture.
“In addition to developing pricing algos and other sophisticated trading infrastructure, market makers have also adjusted their internal setups so that ETF trading is more integrated with macro and single line bond trading desks. More recently, ETF-related infrastructure is being used to facilitate not only ETF trading but also electronic portfolio trading by trading platforms. In turn, these eco system developments are leading to further efficiency improvements and trading transparency.
“In this way, contrary to initial concerns, the rise of fixed income ETFs has actually helped to enhance underlying bond market breadth and liquidity, and driven modernisation of European bond markets.”
Looking forward, Blackman says: “We expect to see continued growth in adoption of ETFs by an ever-more diversified investor base and further utilisation of FI ETFs as financial instruments, on both the long and short side. Fixed income ETFs, and corporate bond ETFs in particular, have become the reference instrument of choice for many market participants, for returns, volatility and market sentiment. Over time, we expect the largest and most liquid fixed income ETFs to become a go-to risk transfer tool of choice and compete directly with iTraxx CDS indices.
“Developments such as larger lending pools, bank repo desks starting to trade FI ETFs and the increased activity in options on ETFs will further improve liquidity, while new tools & analytics are already helping investors to analyse FI ETFs alongside other instruments.”
Shulman comments that the evolution of the credit market infrastructure has enabled more credit index products to flourish and to a large extent that’s really started with technological advances made possible through the ETFs.
“ETF liquidity and continuous bond market pricing that comes with it has enabled a diverse ecosystem to develop both on the funded and unfunded side, as well as led to advances in price discovery necessary for efficient markets. We continue to see ETFs playing a key role in this ecosystem,” she says.
“Indexing organises the OTC bond market into coherent building blocks. Tradable instruments that reference fixed income indices such as fixed income ETFs and standardized index derivatives such as Standardized iBoxx TRS and CDS indices transform these building blocks into implementable ideas. We see increased adoption of index instruments such as ETFs for varying use cases. For example, in portfolio construction, getting beta exposure via ETFs and then trading high conviction ideas on top.”
On the market efficiency side, the trend for various tradable credit index products having similar exposure has overall been accretive to the fixed income markets and allows for different tools that can be wielded for given reasons, Shulman comments.
“As an example, whether somebody wants to trade on a fully funded or unfunded basis, or trade pure credit or including duration, on or off exchange, they now have options. In support of this, we’ve seen an evolution in credit market structure. In the last few years, we’ve seen a number of dealers expand their credit trading desks to cover all credit index products, including credit ETFs, Total Return Swaps on iBoxx indices, CDX and iTraxx CDS indices, and now most recently the CBOE iBoxx iShares $ Corporate Bond Index Futures (IBIG + IBHY). With efficient and transparent underlying bond pricing through ETFs as well as liquidity through multi-dealer activity more investors have and will continue to find value in an index approach to credit.”
The final point in the discussion focused on the development of the fixed income ETF options market in Europe.
BlackRock’s Blackman says: “Away from sustainability, another area of innovation we are seeing is in the increased interest in options on ETFs in Europe. The launch of listed options on UCITS ETFs has increased the toolkit of existing ETF users while also bringing in a whole new group of market participants into the ETF ecosystem. From a market structure point of view the impact of having transparency into ETF turnover through BBG, alongside the development of the securities lending or borrow market for FI ETFs has meant that price makers have become comfortable, and they can hedge their risk.
“Many different types of clients have shown interest in options. Similar to the underlying ETF market, the diversification of client type will be important to its success. The obvious first adopters of the products were asset managers, both multi-asset and fundamental fixed income portfolio managers, but we have also seen interest from pension funds, insurance companies, hedge funds and even some private banks,” Blackman says.
“Two benefits which drive the interest are that first, the fact that they are listed and therefore centrally cleared, makes them more efficient from a counterparty and collateral point of view. The second is that because the underlyings are fixed income ETFs which track broad indices, the performance of the underlying asset is closer and hence a better proxy for cash markets than alternatives such as CDS index options.
“From pension funds specifically, we’ve seen interest from some who have historically used equity index options for yield enhancement through selling out-of-the money calls, who are now looking at credit and EM debt ETF options and seeing the same utility but in the Fixed Income market.”
Outside of ETF options, IHS Markit’s Shulman says of the increased adoption of bond index futures: “Since their launch in 2018, the USD Corporate IG & HY Bond Futures (IBIG & IBHY) have gained interest from market makers to trade Futures alongside the ETFs. The trading of these futures has increased quarter-on-quarter, from ~USD2.1 billion Q1 2020 to ~USD19.6 billion Q2’21, with record monthly trading highs in July 2021. The futures settle on indices that are near-identical to the indices underlying US ETFs HYG and LQD. The futures on European indices could be a useful addition to the credit ecosystem. One of the areas to consider for launching futures in Europe would be the level of consistency that can be achieved between the exposure of the futures corresponding to the ETFs. This will be key to ensure the usage of the futures within the ecosystem as a powerful tool to manage credit risk in portfolios.”