As ETF products gained popularity in recent years, those focused on fixed income have seen muted interest compared to equity products, which got a lift from the decade-long bull run in the stock market. But that has changed this year as bond ETFs crossed a crucial threshold.
The amount of money in fixed-income ETFs officially passed US$1 trillion last month, reported the Wall Street Journal. That reflects a surge in interest among investors — including those in Canada, who have thrown $5.2 billion into fixed-income ETFs this year through May, according to the latest figures from the Canadian ETF Association (CETFA).
Interest in fixed-income exposure through ETFs has increased markedly even among large institutions like banks and hedge funds. “Two or three years ago, a bank wouldn’t take our calls about fixed-income ETFs,” Bill Ahmuty, head of fixed income for State Street’s SPDR ETF business, told the Journal. “Now they’re calling us.”
Champions of fixed-income ETFs have sung the products’ praises for infusing speed into “the sluggish business of bond trading.” Because a single entity can have dozens or even hundreds of outstanding issues, each with different interest rates, maturity dates, and terms, many trades are still transacted via phone and instant messaging; some bonds don’t trade for days or even months.
Since ETFs are obliged to provide real-time values of their underlying portfolios, the managers of the first fixed-income ETFs relied on estimates based on derivatives prices, interest rates, transactions in similar bonds, and other types of proxy information.
Critics have warned that such ETFs could accelerate a selloff if panicked investors were to flood the debt market with more sell orders than it could handle. Among the commonly cited risks is that of distorted bond pricing; Caitlin Dannhauser, an assistant professor of finance at Villanova University, has done research suggesting that bonds that are more exposed to an ETF exodus sustain a more serious hit during bouts of volatility than those that aren’t. Should bond prices take a beating, firms could find it harder and more expensive to borrow money.
“It could be really disruptive for a company that has a lot of bonds exposed to ETF outflows,” Dannhauser said.
Advocates of bond ETFs have dismissed such claims. Rob Kapito, president and director of BlackRock, pointed out that less than 1% of the world’s debt is owned by ETFs, with over US$100 trillion still left to be repackaged into ETFs.
“A lot of [skeptics] have been trying to find a fault with this thing,” Kapito said. “It’s a pent-up desire that hasn’t been fulfilled, because it actually works.”
That certainly seems to be the view of investors in the US, whom Morningstar says have been flocking to bond-based ETFs since 2018 came to a close. Over the first half of 2019, taxable corporate and government bonds underwent an 11.5% increase in flows in the first half of 2019; municipal bonds saw a 9% gain, while US equity ETFs lagged significantly with just a 3% rise in inflows.
“We’re seeing a flight to quality,” Todd Rosenbluth, director of ETF and Mutual Fund Research at CFRA, told CNBC. “So, investors have pushed down yields, and as a result, they’re using ETFs to be able to take on additional risk.”
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