Mixed Bond Flows Tell Bullish ETF Tale

September 19, 2013

Don’t think big bond mutual fund outflows tell the whole tale. But bond ETF inflows just might.


Investors have yanked $24 billion from bond mutual funds in the first two weeks of September, putting September already on track to being the fourth consecutive month of sizable redemptions from the segment. But they have also poured some $3 billion into bond ETFs, which seem to be continuing to chip away at mutual funds’ dominance by virtue of their lower costs, according to IndexUnvierse and TrimTabs Investment Research data.

TrimTabs reported this week that bond mutual funds and ETFs combined saw net redemptions of $20.3 billion in September through Friday, Sept. 13—already the fifth largest monthly outflow only halfway through the month. Those outflows in the mutual fund space come at a time when the ETF market as a whole has just hit a new record high asset level of $1.590 trillion following strong net inflows so far this month.

“We’ve seen unprecedented redemptions from bond funds since the start of the summer,” said David Santschi, Chief Executive Officer of TrimTabs. “The outflow of $68.6 billion in June was the biggest ever, and the outflow of $37.4 billion in August was the third-biggest ever.”

What’s interesting is that while bond mutual funds have lost assets every month since June, bond ETFs have been net gainers in the period, particularly in the short-end of the curve, in what could be an indication of investors trimming their exposure to duration exposure in mutual funds, and choosing to reallocate those assets in shorter duration—and lower-cost—ETFs.

“Once you're on board with indexing, ETFs make vastly more sense as your choice of exposure for all the obvious reasons: cost, tax efficiency, liquidity and transparency,” IndexUniverse President of Research Dave Nadig recently said.

In fact, a look at September flows so far shows that the iShares 3-7 Year Treasury Bond ETF (IEI | A-77) alone attracted a net of $2.7 billion in the first two weeks of the month—or nearly the entire amount in creations seen in U.S. fixed income ETFs in the period, according to IndexUniverse data.

The fund, which ignores any notes with a maturity below three years, captures a little more yield than ultra-short-term bond funds—currently at 1.23 percent—but is nowhere nearly as sensitive to interest rate fluctuations as longer-dated debt is, something many investors have looked to avoid as they await the tapering of quantitative easing.

“The yield on the 10-year Treasury note has jumped 120 basis points since the end of April, which is an enormous move,” Santschi said.  “We think the backup in yields has been driven partly by repayment of cheap European Central Bank loans that were used to buy Treasuries and partly by investor fears of ‘tapering’ by the Federal Reserve.”

That tapering was expected to begin this week in the form of a Federal Reserve announcement Wednesday that never came. Instead, surprising the market, the Fed decided to retain its $85 billion-a-month bond-buying program for now in part because the central bank fears that the upcoming debt-ceiling debate in October might derail a still-fragile recovery.

That surprising move pushed yields on 10-year Treasurys lower 14 basis points to 2.70 percent Wednesday—off from as high as 2.98 percent at the start of the month, but sharply higher than the 2.18 percent in early summer. It also offered a shot in the arm for long-date bond ETFs, at least momentarily. Funds like the iShares 20+ Year Treasury ETF (TLT | A-78) jumped 1.5 percent in price following the Fed announcement.

“Many investors who loaded up on bonds in recent years didn’t fully understand the risks of what they were buying,” Santschi said.  “Now that they’re suffering losses in funds they thought were low-risk, they want out fast.  The exodus suggests ‘tapering’ could be more disruptive than Wall Street thinks.”


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