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 steadiness sheets.

Though these holdings usually are not as huge as complete authorities debt, the best way the Fed performed this financial coverage intervention was relatively novel. It purchased shut to six% of the whole property beneath 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 members have advanced 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 at this time the world’s prime 5 asset administration companies 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 necessary than ever.

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

Company Bond Market Purchase-Aspect 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 danger of every of those markets globally.

However whereas the issuer perspective is vital for assessing threat, buyers must also contemplate the buy-side of the market.

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

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

To evaluate these traits, we used Bloomberg information to construct an aggregated view of all of the funding companies advising or instantly holding securities included within the ICE-BofA International Company and HY indices. This universe of two,847 funding administration firms covers 33% of the whole 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 companies.

What explains this heightened focus? The mutual fund universe affords some perception. Mutual funds are probably the most actively traded buy-side entities and given their higher 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 have to be taken into consideration. For the sake of completeness, now we have additionally included so-called “Combination” 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 Firms 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 at present working in an oligopolistic construction with potential impacts on value formation, liquidity, and the energetic administration trade as an entire.

Whereas the ETF sector’s share of complete 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 ETFs, as are barely greater than 12% of HY-focused funds.

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

The rise of ETF investing within the company bond market is essentially pushed by the ETF’s skill 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.

For the reason that GFC and the following regulatory restrictions positioned on monetary establishments, ETFs have turn into the primary liquid devices accessible to numerous 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 over the past three to 5 years. 

ETF Share of USD Fastened-Revenue Fund Inflows

The Fed’s choice to incorporate these devices in its pandemic-related QE packages acknowledges this actuality: The liquidity of company bonds depends upon ETF buying and selling situations.

But evaluation of the US ETF fairness and fixed-income universes exhibits this premise is just not wholly correct. Excluding probably 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 usually and incur extra volatility in addition to increased price of liquidity when ETFs come beneath promoting stress.

After all, ETF autos 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 complete market threat premium over the long term.

Given this context, the oligopolistic market construction that has shaped because of the affect of ETFs needs to 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.

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

Picture credit score: ©Getty Pictures / halans

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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 group. 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 college) 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 accountable 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 get together asset administration. On this function, she was accountable for quite a few 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 quite a few main asset administration and personal banking companies whereas additionally bringing a robust educational 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.