4 Things To Know About Fixed Income ETFs

Investors have poured over $45 billion into fixed income ETFs so far this year, as of 31 May, according to BlackRock data, but investors still have unanswered questions about these funds in Europe – how do they work? What do they replicate? And are they liquid?

iShares' Brett Pybus, head of fixed income product strategy for EMEA, and Brett Olson, head of fixed income for EMEA, attempted to answer these questions yesterday at a press briefing. See below for the most important round-up of key points.

1) Extra Liquidity When Times Are Good

ETF investors have the ability to sell or buy on exchange, regardless of what the underlying market is doing. This is in stark contrast to investors in actively managed bond funds. Therefore the spread can become tighter on the ETF than the assets it invests in. This is because there are more buyers and sellers on the exchange, netting off transactions, with no need for the market maker to source bonds or for the ETF manager to trade securities.

“In extremis, owning an ETF does not put you in any worse a situation than holding the underlying securities,” said Pybus.

The ETF is a product which is linked to the cash bond market. It acts as a shock absorber but if times are bad and everything tanks, the ETF might not provide any more liquidity.

“If you’re holding a European high yield bond ETF, in extremis you’re still bound by the liquidity of that underlying market,” he said.

2) NAV Calculates Once A Day

Bonds might not trade every day so ETF issuers need their own way to measure the value of their underlying assets. The ETF calculates its net asset value every day. The ETF starts trading – supply and demand will mean the ETF can trade up or down a little – while authorised participants will seek to arbitrage price differences away for profit. But in a broad-based sell off, the ETF could go to a discount.

Pybus argued that the discount is actually reflecting the price of the market.

“Particularly during a sell-off, investors might say, “this ETF is trading at a discount and it’s wrong”, and we say it’s not wrong, it’s trading where the market is and gives you a window into the risk and prices where investors are willing to trade,” said Pybus.

3) Fund Size Matters

Olson said that there would be more trading activity with a fund of over $1 billion and therefore it is more liquid, allowing you to trade it at a narrower bid/offer spread.

“For example if it was a new ETF, and it’s small in size, you’re not going to see the same level of activity,” he said.

4) MiFID II Will Bring Price Transparency

The Markets in Financial Instruments Directive (MiFID) II, which comes into force in 2017, will require all over-the-counter (OTC) trades to be reported and will show investors the true liquidity of a product. As most bonds are traded OTC, the new European directive will shine a light on fixed income ETFs and their underlying assets in particular.

“I think that will be a game-changer in terms of the visible liquidity you can see in products,” said Olson.