This is part of a series on the global rise of exchange traded funds
How do you buy or sell bonds if the middleman is not there any more?
As any bond investor will tell you, buying or selling bonds is harder and more costly than in long memory. Since the crisis, regulators have squeezed the investment bank with ever-tighter capital, liquidity, and conduct rules. These rules have shrunk the bank’s balance sheet — and its ability to play middleman. In 2008 global banks held almost $250bn in bond inventory. Now they hold less than $50bn. Meanwhile, the US corporate bond market has swelled from about $2tn to nearly $6tn outstanding. So where should the bond investor turn?
As the bond market talks about electronic trading on platforms one day, the bond ETF is making it happen on exchanges today. ETFs have become the easiest way for US and European investors to trade bond risk without a middleman. The bond ETF is adding liquidity, sharpening price discovery, and reducing pressure on banks’ balance sheets, especially under stress.
For many investors, the ETF — a bundle of stocks or bonds — is just a low-cost way to execute long- or short-term investment ideas. For them, the ETF is the Amazon Prime or Uber of investing: quick, simple, low-cost, convenient, and full of choice.
For bond investors, the ETF offers something more: an all-to-all technology to buy and sell the bundle like a stock. The investor trades directly with other investors on an equity exchange, at a public price, open to retail and institutional on the same terms. This is a transformational concept in the bond markets. A market dependent on middlemen has begun to offer a supplementary way to trade. What was opaque, over the counter, and principal-driven is moving towards brightly lit, standardised and agency-driven.
To some bond hands, this new technology seems like an inversion of nature. How can a bond trade like a stock? It cannot — but if we bundle it with other, like bonds, we create a standardised package that investors can trade more cheaply. And if we trade this bundle on an equity exchange, open to all, we have the ETF.
Take the high-yield markets. It costs about 50 basis points to buy a bunch of high-yield bonds in the US, or you can pay 1bp in spread for the same exposure in a liquid, high-yield ETF. In the Eurozone, the high-yield bonds will cost 60 to 70bp — or you can pay about 13bp for an ETF. By standardising bundles on an exchange, buyers and sellers can meet directly, in public, in real-time, and the bundle can be cheaper and more liquid than the underlying market.
The high-yield energy fears of a year ago show how this new market operates. Under stress, bond investors turned to this fresh node of ETF liquidity potential. Secondary volumes surged: high-yield bond ETFs traded on exchange for an average of $3bn a day, compared with $9bn in the underlying cash market and another $6bn for index credit derivatives. All those bond ETF trades were incremental liquidity for the market, with not a single bond changing hands.
This year, whether via the Brexit vote or the US election, bond ETFs have kept growing and trading without issue. Yields on US Treasuries have recently backed up 100bp, and again no issues (nor for the market as a whole). ETFs are becoming a fixture in the modern bond investor’s toolkit: simple, transparent, efficient to trade. Active bond managers, sovereign wealth funds, insurers, wealth managers, individual investors, and central banks themselves are all using bond ETFs to build their portfolios.
By creating exchange trading of bond risk, ETFs can also help ameliorate the financial system’s vulnerability to shock. The old market depended on leveraged firms for intermediating risk, whether through cash bonds or derivatives. The new market offers another, unleveraged way to trade.
The future bond market will combine the old and the new. Most buyers and sellers want to trade a specific bond. There, the traditional, principal-based, over-the-counter middleman model is likely to still dominate. But new, hybrid models are sprouting in its shadow. Electronic trading venues, open to the whole bond market, are gaining ground. And bond ETFs are likely to keep growing as a liquid, efficient way to trade and invest in standardised bundles of bond risk, especially under stress.
Mark Wiedman is global head of iShares and index investments at BlackRock. Also written by Richie Prager, global head of trading, liquidity and investments platform at BlackRock
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