Tucker On Why Institutions Like Bond ETFs

May 18, 2015

Institutional investors have been relying more and more on fixed-income ETFs to navigate shrinking liquidity in bond markets, Matt Tucker, head of fixed income at iShares, tells us.

 

Citing the latest findings of the Greenwich Associates 2015 U.S. Fixed Income ETF Study, Tucker says that fixed-income ETF trading is growing at an annual rate of 33 percent, and the pace of adoption by institutions is only expected to grow.

 

ETF.com: The survey found that institutions are increasing their use of fixed-income ETFs due to structural changes in debt markets. What are some of these changes that have been driving up ETF demand?

Matt Tucker: We’ve seen pretty significant changes in bond market structure in the past couple of years. Prior to the financial crisis in 2007, 2008, there were a lot more broker-dealers in the market, but we have seen a contraction in the number of players in the market since then.

 

At the same time, post-financial crisis, there have been a number of regulations that came through, such as Dodd-Frank, the Volcker Rule, and other regulations that essentially constrict the amount of capital that broker-dealers can commit to providing liquidity. In practice, that means dealers are not going to hold as many bonds as they did before, so it could be hard for institutions to find them, and the dealer might not be willing to buy bonds from institutions, either.

 

Institutions have had to look around for additional sources of liquidity, and that’s a big part of the growth in adoption of fixed-income ETFs. More than half of the firms surveyed have faced liquidity problems in trading individual bonds. That has encouraged them to try new things, and led them to ETFs.

 

ETF.com: Does this liquidity crunch impact bond ETFs as well?

Tucker: A bond ETF holds bonds, yes. But most of the trading that occurs in a fixed-income ETF does not involve bonds actually changing hands. There’s a ratio in the ETF market that shows that for every $8 of fixed-income ETFs traded, only $1 of actual bonds have to be traded to support that.

 

Since only one-eighth of the transaction actually involves bond trading, ETFs are able to provide more liquidity to investors in the market while lessening the burden of the draw on underlying bond market liquidity.

 

ETF.com: So is liquidity in the bond ETF segment actually increasing with all this new demand?

Tucker: Yes. The survey found that since 2008, ETF liquidity has grown 4 ½ times [at a pace of about 33 percent a year.] Today there’s about $5 billion in bond ETF volume on the exchanges every day. That number is up substantially from previous years.

 

We are seeing these trends about increasing usage going up, and that’s a result of two things: The liquidity in the bond market has decreased; and the liquidity in the ETF bond market has increased. That’s driving more institutional investors to the ETF market.

 

ETF.com: For retail investors, is the relevance of these findings that they, too, should benefit from better liquidity in bond ETFs?

Tucker: The best markets for liquidity are those where you find the broadest number of participants—individual investors, financial advisers, pension funds, insurance companies, all transacting in the market. So, to individual investors, having a growing institutional presence means they have a much healthier ecosystem to tap into.

 

As liquidity has increased, bid/ask spreads have narrowed, so transacting in bond ETFs is a lot cheaper, and this execution efficiency is available to all investors.

 

 

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