How Bond ETFs Changed Investing

October 22, 2018

[This article appears in our November 2018 issue of ETF Report.]

Before bond exchange-traded funds launched in 2002, accessing the fixed-income market wasn’t always easy. Investors could own individual bonds—but because of the size and cost, institutions mostly bought them. Smaller investors could buy actively traded mutual funds and pay higher fees and not be sure of the holdings.

When four bond ETFs launched in 2002—the iShares 7-10 Year Treasury Bond ETF (IEF), the iShares iBoxx USD Investment Grade Corporate Bond Fund (LQD), the iShares 1-3 Year Treasury Bond ETF (SHY) and the iShares 20+ Year Treasury Bond ETF (TLT)—with the iShares Core U.S. Aggregate Bond ETF (AGG) coming a year later, they offered a cheaper and more transparent way to own bonds. In particular, AGG’s launch gave investors a way to own exposure to the Bloomberg Barclays U.S. Aggregate Bond Index, the predominant fixed-income benchmark.

Todd Rosenbluth, senior director of ETF research for CFRA, says bond ETFs democratized the bond market.

“It’s made it much more accessible for investors to either get broad exposure, or to be able to target the approach that they want, whether it’s to reduce their credit risk or take on credit risk, whether to be more sensitive to rising interest rates and/or to benefit from active management but using the ETF wrapper,” Rosenbluth said.

The bond market still largely trades over-the-counter, making price discovery generally opaque. Prior to bond ETFs, Heather Brownlie, managing director and U.S. head of BlackRock’s fixed-income iShares, says investors wanting to buy bonds needed trading relationships with dealers, and had to call different desks depending on the type of debt instrument.

“It was just a pretty cumbersome way to do price discovery,” she said. “So that’s why it really favored the largest institutions.”

And buyers didn’t know if the price they were quoted was fair. Having an ETF like AGG changed that. “Any investor could get immediate access to diversified pools of bonds,” noted Brownlie, “but also have the transparency of pricing right there on the exchange.”

Broadened Range
Elisabeth Kashner, CFA, director of ETF research at FactSet, says bond ETFs opened up the range of passive exposure. And just as with equity ETFs, bond ETFs have benefited from investors’ desire for passive investing. Looking at the breakdown of active and passive bond ETFs, 93% of assets under management (AUM) were in passive bond funds as of June (see Figure 1).

 

 

Kashner says bond ETFs also gave investors greater choice: “You have a much wider variety than you might’ve been able to find in the mutual fund format, when you start looking at things like the emerging market sector or a specific country exposure, or some of the really niche areas that we’ve been seeing, like some ESG exposure in the past couple of years.”

While bond ETFs remain a small part of the ETF landscape in general, and haven’t caused the mass exodus from mutual funds like equity ETFs did, assets are flowing there. Kashner cites Investment Company Institute data showing that while bond mutual funds still see healthy inflows, the ETF space is growing much faster in terms of its asset base.

Bond ETF investors also benefit from the holdings transparency, liquidity and low cost that come with the ETF wrapper. AGG’s expense ratio, the biggest bond ETF by AUM, is 5 basis points, versus 15 basis points for Vanguard Total Bond Market Index Fund Investor Shares and 57 basis points for PIMCO Total Return II Fund Institutional Class, two of the top bond mutual funds.

Rosenbluth says liquidity is a big selling point for bond ETFs. Some parts of the bond market can be illiquid, and some bonds may not trade daily.

“[ETFs] make it much more liquid, because most of the time when you’re buying or selling an ETF, you’re trading with somebody else as opposed to new shares being created or redeemed,” he said. “The liquidity is enhanced as long as there’s somebody else on the other side of the trade. The fact that there are multiple market makers significantly increases the likelihood that somebody is willing to execute that trade with you.”

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