There is a running theory on Wall Street that the billions of dollars flooding into exchange-traded funds (ETFs) will make their component securities easier to trade. That would be welcome news for the $40 trillion U.S. bond market, where liquidity — or the ability to buy and sell easily in reasonable size — has been dwindling.
Unlike stocks, most bonds are still traded over the counter by voice, reflecting the long-held habits of traders trying to locate hard-to-find securities and their decades-old relationships with dominant securities dealers. But bonds have become costlier to trade in large size, partly because of rules requiring dealers to report transaction prices and because of a wave of post-crisis banking rules.
ETFs may help alleviate the strain. Investors are increasingly adopting ETFs as part of the passive investing trend and, according to a 2017 study by Greenwich Associates, in some cases using ETFs to replace bonds and derivatives.
The funds have become popular because they are comparatively low-cost, diversified and relatively transparent instruments that trade on exchanges like common stocks do, even though their components are securities.
Of the respondents in last year’s Greenwich Associates poll who said they were switching into ETFs, 58% said it was to lower costs. For these investors, it can be more efficient to buy and sell ETF shares because it means buying one ticker, rather than hundreds of different debt securities.
ETFs may help usher in a new trading ecosystem in the bond market, which has been trying to make the leap from telephone to screen trading for years. “The great irony is that what will electronify fixed income is equities,” says J.C. Mas, head of equity and ETF trading at BNY Mellon Markets in New York.
Wall Street has steadily embraced the ETF wrapper as one of the tools to help increase circulation among bonds, where daily trading turnover has been falling. This is critical because the array of issuers and maturities outstanding in bonds is many multiples of what is available in stocks.
Average daily trading volumes in individual U.S. corporate bonds fell 9% to $32.5 billion between the first and the second quarter of this year, according to the Securities Industry and Financial Markets Association. Daily Treasury bond trading, by comparison, fell 6.5% to $523.3 billion over the period.
Securities dealers also are keeping smaller inventories, so they are less likely to be holding specific bonds when clients call. Securities dealers have cut their corporate bond holdings by more than two thirds since the 2008 financial crisis. At the same time, issuance has exploded as borrowers took advantage of historically low interest rates to issue record amounts of debt.
ETFs have the potential to bring more liquidity to the bond market. While assets in fixed-income ETFs represent less than 1% of the global bond market, the Investment Company Institute says bond ETFs now number 326, up from 61 a decade ago. Fixed-income exchange-traded products had taken in $1.37 trillion globally as of June, double the amount they had attracted as of 2011, according to data compiled by ETFGI LLP.
ETFs also offer a new way to protect against any number of headwinds: the return of volatility, rising interest rates or geopolitical risk, to name a few. ETFs can help investors jump quickly from one sector to another. There are now smart-beta and factor based ETFs that allow people to zero in on specific investment strategies. And there are listed options on ETFs for when investors are looking to hedge.
BlackRock Inc.’s ETF division iShares says money has been moving into bond ETFs at a faster pace than equities across the U.S. and Europe. Many industry professionals believe that the growth in fixed-income ETFs doesn’t cannibalize the underlying bond market, but rather enhances it. That’s because as more money moves into fixed-income ETFs, the firms that administrate and oversee those funds – desks known as authorized participants -- have to go out and find the components of each basket and are responsible for managing that ebb and flow of securities.
In theory, there should be a virtuous circle between ETFs and bond market liquidity.
BNY Mellon Markets* is both an authorized participant handling the workings behind ETFs as shares are created and redeemed, as well as a market maker showing prices at which the firm is willing to buy and sell ETF shares. The firm is a liquidity provider in all ETFs and a top-five market maker by volume in dozens of fixed-income ETFs, according to Bloomberg LP rankings.
If clients are looking to liquidate, rebalance or consider a tactical move into ETFs, BNY Mellon Markets* can help them maximize their savings by keeping their trading and custody in one place.** The firm offers a one-stop trading solution that can take orders and automatically instruct a client’s custody account to settle.
Contact your usual BNY relationship manager for more information.
*ALL SECURITIES ARE OFFERED THROUGH BNY MELLON CAPITAL MARKETS, LLC.
***Securities trading offered through BNY Mellon Capital Markets, LLC. Custody offered through The Bank of New York Mellon
Securities products are not FDIC-insured. They are subject to a potential loss in value. They are not a Deposit of, or Guaranteed by, a Bank or any Bank Affiliate.
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