Trading places – From bonds to fixed income ETFs

Phil Cichlar, Jane Street

Phil Cichlar, Head of Fixed Income Sales & Trading at Jane Street shares his insight on the burgeoning ETF market.

Phil Cichlar, Jane Street

Fixed income exchange-traded funds (ETFs) are gaining traction and gathering assets. How are these changes unfolding in your world?
Initially seen as access vehicles for smaller investors, fixed income ETFs have traditionally been popular with registered investment advisors (RIAs) and wealth managers. More recently, we’ve seen an uptick from larger institutional investors – including insurance companies, pensions, traditional asset managers, and hedge funds. Most institutional investors started with smaller ticket sizes in the $10-$25 million range; the same users are now trading in sizes of $50 or $100 million – demonstrating increased confidence in fixed income ETFs as their understanding of the product strengthens.
The way that trades are executed is also evolving. Since ETFs are traded like stocks, equity traders have traditionally handled much of the fixed income ETF flow on the buy side. With the growing appeal of fixed income ETFs, this responsibility is now transitioning to bond traders with specific expertise in the underlying cash bond markets.

How does trading fixed income ETFs differ from trading bonds?
From a pricing standpoint, fixed income ETFs offer a consolidated price on-screen that is immediately actionable. Bond pricing tends to be a more opaque and complex process.
From a trading standpoint, the biggest difference between trading fixed income ETFs vs. bonds comes down to mindset. Bond traders need to understand both issuer fundamentals and security-specific technicals associated with their order.
In contrast, fixed income ETF traders need to think more like portfolio managers. They no longer need to have the same intimate understanding of the underlying bonds (although this is always helpful). Since fixed income ETFs represent baskets of risk (e.g. investment grade, high yield, emerging markets), it’s more important to quantify how that risk should be priced. Consequently the fixed income ETF trader can execute one block risk trade, as opposed to multiple line items over the course of many trades.
In many ways, fixed income ETFs are easier to quote than the underlying bonds. While cash bonds may only have a handful of broker dealers who trade in them, ETFs typically have a multitude of liquidity providers. For example, the largest fixed income ETFs have roughly 40 firms that can quote $10 million of risk markets, whereas only a handful of broker dealers can do that on most individual corporate bonds.

What advice would you give to bond traders before they start trading fixed income ETFs?
I would recommend taking time to understand the numerous sources of liquidity. On-screen liquidity only represents of a portion of the total liquidity available in the market. Recently, an institutional client was looking to trade a newly launched fixed income ETF with $30 million in assets and 1.2 million shares outstanding. The market was 12 price basis points wide on-screen, but the market maker was able to source underlying bonds and create shares in the primary market, effectively facilitating a client trade of 380,000 shares on the offer.

Are institutional investors changing how they use fixed income ETFs?
While fixed income ETFs were initially used for core exposures and tactical tilts, institutions are becoming more innovative in how to deploy them:
• Hedging – Some institutions have found that fixed income ETFs can be a better hedge than derivative products like credit default swaps. During the big energy sell-off in late 2015, credit investors tracking bond indexes found themselves using high yield ETFs as a hedge to compensate for the lack of energy exposure in the CDX index.
• Consolidating Positions – Some asset owners work with issuers and market makers to consolidate a portion of their non-core bond positions into a fixed income ETF. Substantial cost savings are available vs. selling the entire portfolio, and the ETF can be traded on exchange and in block size – making the trading desk more efficient.
• Execution Management – We’ve also observed a number of institutional investors doing the reverse – redeeming a fixed income ETF and taking delivery on the underlying basket of bonds. This conversion trade allows the asset owner to gain access to hundreds of line items without burdening the trading desk, streamlining the execution process.

As more institutions start trading fixed income ETFs, how should they think about which counterparties to work with?
Traditionally, investment banks have been the default counterparty for bond traders. The situation is more nuanced for fixed income ETFs.
Given the regulatory environment, investment banks are re-evaluating how they allocate their balance sheets, and many are pulling out of lead market maker (LMM) roles for ETFs. In contrast, ETFs are the primary focus for firms like Jane Street, and we are LMM on 65 out of over 300 fixed income ETFs listed in the US.
Moreover, independent market makers commit their own risk capital to help clients buy and sell ETFs with tight spreads. As a core proficiency, market makers are more likely to provide liquidity during periods of market dislocation and volatility.

Bond markets are seeing a mass movement towards electronic trading. How is the same trend affecting fixed income ETFs?
For cash bonds, request for quote (RFQ) platforms have traditionally facilitated pricing and liquidity transparency. When it comes to fixed income ETFs, RFQ allows institutional investors to put market makers and banks in competition for order flow, facilitating best execution.
Both cash bonds and fixed income ETFs are available on the same RFQ platforms. For institutions already trading cash bonds electronically, they can easily use the same workflow to get started with ETFs too.

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