Central banks took an enormous leap on the street to direct market intervention in 2020. All developed market central banks added direct purchases of company bonds to their quantitative easing (QE) packages. As of 31 December 2020, the European Central Financial institution (ECB) and the US Federal Reserve held €250 billion and €46 billion in company bonds on their respective stability sheets.

Though these holdings usually are not as large as whole authorities debt, the way in which the Fed carried out this financial coverage intervention was slightly novel. It purchased shut to six% of the full property underneath administration (AUM) in US company bond exchange-traded funds (ETFs) and outsourced the execution to BlackRock.

It was simply the most recent illustration of how buy-side credit score market individuals have developed for the reason that world monetary disaster (GFC). Over the past decade or so, the buy-side construction has grown extremely concentrated, a lot in order that in the present day the world’s prime 5 asset administration corporations command greater than 27% of worldwide credit score AUM.

On the identical time, efforts by regulators to discourage extreme risk-taking by monetary intermediaries has restricted the latter’s capability to offer market liquidity. Concurrently, low rates of interest and central financial institution bond shopping for have inflated company bond issuance, making the necessity for liquidity services extra essential than ever.

Consequently, many market individuals have turned to ETFs. Why? As a result of they consider that — as intra-day traded devices invested in lots of index-tracking securities — ETFs can present an alternate supply of liquidity.

Such considering is flawed. Funding in these securities has considerably elevated ETFs’ prominence available in the market and established a brand new sort of huge and essential buy-side investor within the type of the ETF sponsor. However this investor might not have the identical funding targets or incentives as its conventional buy-side counterparts

Company Bond Market Purchase-Facet Construction

For a few years, credit score markets have been notoriously uncovered to issuer focus threat. The Monetary sector in funding grade (IG) and the Power sector in excessive yield (HY) signify 15% and greater than 20%, respectively, of the chance of every of those markets globally.

However whereas the issuer perspective is important for assessing threat, buyers also needs to think about the buy-side of the market.

The worldwide bond market’s present buy-side construction is difficult to explain objectively. Bonds are typically immediately held by non-financial entities or by liability-driven buyers that don’t all the time report all their holdings publicly. For instance, information from the Fed’s Circulation of Funds present that funding funds whole near 30% of the company and overseas fixed-income property held by US entities. Insurance coverage firms are the biggest homeowners of those property with a 37.5% share of the full as of 31 December 2020.

This helps clarify why the results of buy-side focus and the results for the company bond market construction have thus far been largely ignored.

To evaluate these developments, we used Bloomberg information to construct an aggregated view of all of the funding corporations advising or immediately holding securities included within the ICE-BofA International Company and HY indices. This universe of two,847 funding administration firms covers 33% of the full world IG and 41% of the worldwide HY indices. Our evaluation confirmed a cloth focus on the investor aspect: 45% of IG and 50% of HY markets are held by the highest 10 funding corporations.

What explains this heightened focus? The mutual fund universe gives some perception. Mutual funds are essentially the most actively traded buy-side entities and given their better availability, they permit for extra in-depth evaluation. However company bonds are eligible investments for a lot of different fixed-income methods, so the universe past company bond-focused mutual funds should be taken into consideration. For the sake of completeness, we’ve additionally included so-called “Mixture” methods in our evaluation, together with company bond-focused ones.

The chart beneath highlights the extent of buy-side focus: The highest three asset administration firms signify 28% of AUM, whereas 90% of company bond ETF property are managed by solely three firms.

AUM Focus amongst Administration Corporations by Fund Kind

Passive Investing’s Function in Bond Markets

No matter one’s perspective on passive investing or the ETF as an funding car, this market is presently working in an oligopolistic construction with potential impacts on value formation, liquidity, and the lively administration trade as a complete.

Whereas the ETF sector’s share of whole mutual fund trade AUM began to rise earlier than the GFC, it accelerated considerably within the aftermath of the disaster. Although ETFs quantity to 9% of the general funds in our evaluation (together with the so-called mixture methods), greater than 25% of company IG-focused mutual funds are invested by means of ETFs, as are barely greater than 12% of HY-focused funds.

Share of Passive Funds (ETFs) in Mounted-Revenue Mutual Fund Universes by Technique

The rise of ETF investing within the company bond market is essentially pushed by the ETF’s means to effectively replicate broad indices in addition to its exchange-traded function. The latter high quality alleviates problems with value transparency and makes the safety accessible to a broad set of buyers.

Because the GFC and the following regulatory restrictions positioned on monetary establishments, ETFs have turn out to be the primary liquid devices obtainable to varied buyers for managing credit score publicity. The ETF’s share of flows into or out of the asset class are much more spectacular: ETFs accounted for nearly 50% of inflows into IG company funds and 30% into HY during the last three to 5 years. 

ETF Share of USD Mounted-Revenue Fund Inflows

The Fed’s determination to incorporate these devices in its pandemic-related QE packages acknowledges this actuality: The liquidity of company bonds will depend on ETF buying and selling circumstances.

But evaluation of the US ETF fairness and fixed-income universes exhibits this premise will not be wholly correct. Aside from essentially the most liquid decile of Treasuries funds, fixed-income ETFs seem two- to five-times much less liquid than their fairness counterparts. This helps additional clarify the necessity for the Fed’s intervention within the company bond market in 2020.

Most Low cost to NAV for US-Listed ETFs, Common by Deciles, December 2019 to December 2020

Excessive market environments, akin to that of the March 2020 disaster, remind us that whereas ETFs are exchange-traded devices, that alone doesn’t assure that the underlying securities are resistant to liquidity stress. On the contrary: The excessive focus amongst ETF suppliers — amongst ETF replication algorithms — tends to additionally focus buying and selling stress on particular bonds. These commerce extra typically and incur extra volatility in addition to increased value of liquidity when ETFs come underneath promoting stress.

In fact, ETF automobiles usually are not with out prices for buyers. Probably the most ignored amongst these are these associated to ETF bonds’ common premium together with the issuer threat concentrations inherent in underlying debt-weighted company bond indices. For these causes, company bond ETFs don’t gather the total market threat premium over the long term.

Given this context, the oligopolistic market construction that has fashioned as a result of affect of ETFs must be acknowledged.

Within the second a part of our evaluation, we are going to lay out the implications this has for buyers looking for to generate alpha from fixed-income markets and thus for portfolio development itself.

In the event you preferred this submit, don’t neglect to subscribe to the Enterprising Investor.

All posts are the opinion of the writer. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially replicate the views of CFA Institute or the writer’s employer.

Picture credit score: ©Getty Pictures / halans

Skilled Studying for CFA Institute Members

CFA Institute members are empowered to self-determine and self-report skilled studying (PL) credit earned, together with content material on Enterprising Investor. Members can report credit simply utilizing their on-line PL tracker.

Axel Cabrol, CFA

Axel Cabrol joined TOBAM in June 2016 as a credit score portfolio supervisor from Butler Funding Advisory the place he co-managed the WB Alternatives Fund, a long-short credit score fund invested in European company high-yield bonds. Previous to that, he spent two years at Barep AM, managing the Barep International Credit score Fund in the identical 4 portfolio managers staff. From 2003 to 2005, he traded European authorities bonds at Caisse des Depots (CDC) and from 2005 IG bonds for one 12 months. Cabrol graduated in 1999 from ENSAE (main French engineering faculty) with a focus in statistics, actuarial research, finance, and synthetic intelligence and has a post-graduate diploma in statistics (with excessive distinction) from Université Pierre et Marie Curie, Paris VI.

Tatjana Puhan, PhD

Tatjana Puhan, PhD, is answerable for the funding administration actions at TOBAM, overseeing the analysis and portfolio administration groups. She joined TOBAM from Swiss Life Asset Managers the place she was head of fairness and asset allocation for third celebration asset administration. On this position, she was answerable for various the corporate’s flagship methods, most notably its funding options using systematic and proprietary quantitative approaches, in addition to contributing to Swiss Life Asset Managers’ asset allocation and fairness analysis initiatives. Dr. Puhan has greater than 15 years’ funding expertise, labored at various main asset administration and personal banking companies whereas additionally bringing a robust tutorial and analysis background. Dr. Puhan holds a grasp’s diploma in finance and enterprise administration from the College of Hamburg and earned her PhD in finance from the Swiss Monetary Institute on the College of Zurich, with analysis fellow appointments on the College of Zurich, Kellogg Enterprise Faculty (Northwestern College), and the College of Hamburg. She is a lecturer in finance on the College of Mannheim and an related researcher of the Hamburg Monetary Analysis Middle.