In September, 60% of ETF flows went into fixed income products. Traders are working to squeeze everything they can out of the boom.
When it comes to bond trading, traditional desks have increasingly noticed an elephant in the room: exchange-traded funds.
“September was a global record for inflows in bond ETFs, just shy of US$100 billion globally,” reported Alex Claringbull, global head of index investments at BlackRock, during
Bloomberg’s Future of Fixed Income Forum in London last week.
“ETFs have completely changed how fixed income is traded. A typical bank is now set up with an ETF desk.”
That is scant comfort to Edouard Faure, head of credit at
Swiss Life Asset Managers, who doesn’t trade ETFs, “There are days where there’s huge flows in bond ETFs. If there are outflows of the ETFs, and you also have outflows of your funds, then it becomes more difficult to get a decent bid ask spread” he told the FILS Europe audience.
“When trading in size, dealers often widen quotes to compensate for information-leakage risk”, explained Simon McGhee, head of fixed income aggregation at Virtu Financial. “This is where existing technology can add the most value, by adapting equity algos for cash bonds and fixed
income ETFs,”.
McGhee added, “existing ETF-aware algos already sweep exchanges and systematic internalisers, ping lit and dark liquidity, then launch an RFQ to finish the balance. These tools are available today, but they’re not yet top of mind for most bond market participants. We’re working to give traders more choice, across both venues and methods of execution.”
That message is starting to be heard by traditional buyside bond traders. “Historically ETFs
were tactical, now they are core allocations,” agreed Raphael Stern, global head of fixed income PM, ETF and indexed investments at Invesco. “It’s a tool that’s being assessed for any type of trade.”
At FILS Europe earlier this month, one buy-side trader noted that ETFs have improved access to liquidity – and provided that access at a lower bid-offer spread than the underlying assets.
“It’s incredible. It means that over even a relatively liquid part of the fixed income market, you can create something that is more liquid and more accessible to the investor,” they said.
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Another panellist added, “We have been going through recent areas of stress. We haven;t seen any forced selling. Our investment teams don’t need to trade today in cash, but we can play it out in ETFs. We’ll take a position or hedge through iTrax. We’re happy to take our time, we don’t fully sell up in these instances.”
ETFs are also a popular tool for market makers seeking to hedge their risk trades.
“They execute at different times of the day. They may hedge immediately by trading the cash basket, or proxy-hedge using futures that are later unwound as the cash basket trades out,” McGhee explained.
The popularity of ETFs in fixed income shows no sign of slowing down. BlackRock expects global bond ETFs to be valued at US$6 trillion by 2030. In June, JP Morgan predicted US$7 trillion in value by that time.
As the ETF market continues to grow, investors and traders are discovering new ways that the asset class can be put to work.
Innovations
Particularly growing in popularity is the active fixed income ETF.
As Stern explained, “Traditionally, active means you’re going away from market weighted. It gives the portfolio manager flexibility to give you good basket exposure. Sometimes you might want to add a little bit of active alpha to your core exposures. In some situations you might not want to be market weighted – take France right now. You might not want to be market weight in European govies. With an active govie ETF you can add some corporates in.”
It is possible to get this exposure in a passive ETF, he added, but this is a far more difficult, timely process.
“There are more exciting things you can do in an ETF now that you couldn’t a couple of years ago, and some of those opportunities are better suited to an active approach.”
Emerging markets are another space where an active approach can really pay off, added Rufaro Chiriseri, head of fixed income for Europe at RBC Wealth Management, noting levels
of dispersion in these regions.
Others, however, are more skeptical about the progress of the fixed income ETF.
“There was a lot of talk about fixed maturity ETFs, but the AUM didn’t grow that much,” said Luca Pagni, head of ETF fixed income and FCPE portfolio management at BNP Paribas Asset Management.
On a broader level, he added, “I think there is a misconception in the growth of active FI ETFs. There are a lot of new funds being launched, but the growth in AUM is not spectacular.”
Part of Pagni’s stance on the market is due to the uncertain definition of what an active ETF really is. He notes that overnight and CLO ETFs are, technically, categorised as active, despite the fact that there is no way for them to be passive.
Other innovations in the space have included the introduction of fixed maturity ETFs, whereby investors benefit from a predetermined yield akin to a single bond.
Claringbull argues that the industry has barely scratched the surface of what it can do with these products, highlighting Italy as a market leader.
Protocols
When it comes to trading ETFs, Stern said “About 75% of volume trades by RFQ in Europe. There’s volume there, and a lot of retail flow. Various platforms will trade that way. I think in the US it’s exactly the opposite, there’s a lot more volume on exchange and less RFQ.
“Given the fragmentation of markets and the multiple currencies, regulators and jurisdictions in Europe, liquidity is going in different directions. That’s one reason that the market makers are playing a bigger role through RFQs, finding that liquidity and showing it to you in a central place.”
“ETF technology now seems quite common – we talk about portfolio trades all the time, that started in ETFs,” Claringbull said, noting the impact of ETFs on the broader landscape.
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The message seems to be: if you don’t want to be one of the have-nots, you had better include ETFs in your trading toolkit.
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