Exchange Traded Funds

Shifts in bond markets and rates drive institutional usage of fixed income ETFs

Institutional investors are using fixed income exchange traded funds (ETFs) as they adjust their portfolios to adapt to post-financial crisis regulatory changes and rising interest rates.

That’s according to a new report, Institutional Investors Turning to Fixed-Income ETFs in Evolving Bond Market, from Greenwich Associates.

Changes to fixed income portfolios of corporate and public pensions, foundations and endowments, investment managers, large registered investment advisors, and insurance companies are revealed in the first US fixed income ETF study by independent research firm Greenwich Associates and sponsored by iShares, the ETF business of BlackRock.

The current and expected future use of fixed income ETFs with the backdrop of a changing bond market indicate strong growth of fixed income ETFs. A large percentage of current users (85%) have employed fixed income ETFs for at least two years and 66% of users have increased their usage since 2011.

Other key findings in the research are: 1) around 80% of institutions surveyed use fixed income ETFs for ease of use and liquidity to help them access bonds in the post-financial crisis bond market; 2) nearly 50% of institutions have quickly progressed their use of fixed income ETFs from tactical to strategic; and 3) out of the non-users who plan to use fixed income ETFs in the coming year, 67% plan to allocate 6-10% of their fixed income portfolio to ETFs.

Institutions report ease of use and liquidity as the main reasons to use fixed income ETFs, 81% and 80% respectively. The impact of post-crisis regulatory changes is challenging institutions to reposition their portfolios. New regulations have lowered dealer inventories, driving down trading volumes and liquidity for individual bonds. Meanwhile, the liquidity of fixed income ETFs has increased significantly and since fixed income ETFs launched in the US in 2002, their assets have grown considerably to about USD246 billion as of December 20132.

Matthew Tucker, Head of iShares Fixed Income Investment Strategy at says: “Institutions are re-examining their fixed income portfolios in light of an evolving market that is characterised by increased volatility, decreased liquidity and more challenging access. These trends are leading investors increasingly to fixed income ETFs as a way to source exposures, harness liquidity and efficiently implement desired investment strategies.”

Most of the institutions surveyed (65%) have made changes to their fixed income portfolios, shifting sectors and accordingly demanding new ETFs to meet their needs. Institutions most common changes to their portfolios have been to shorten duration and to move into sectors that offer potentially higher yields such as corporates, high yield, and international and emerging markets bonds as they prepare for a gradual, long-term increase in interest rates.

Greenwich reports that these portfolio changes are expected to continue and perhaps even accelerate in the year ahead. Demand for new ETF products is strongest in areas that can potentially boost yield and manage interest rate risk. The highest demand is for fixed-maturity ETFs (80% of respondents).

By investor type, around 80% of investment managers and large RIAs surveyed use fixed income ETFs to obtain long-term exposures in the core component of their portfolios, while 63% of institutional funds and 56% of insurers use fixed income ETFs as long-term, core exposures.

As further evidence of the strategic use of ETFs, nearly 60% of current users allocate 10% or more to fixed income ETFs. Greenwich suggests that the evolution of institutional use from tactical to strategic use of fixed income ETFs appears to be taking place more rapidly than their use of equity ETFs.

Greenwich cites that growing momentum of institutional use and increased levels of investor comfort with the product point to rising usage. Nearly half of institutional managers and 38% of institutional funds plan to increase their fixed income ETF investments in the next 12 months. Out of the non-users who plan to use the ETFs in the coming year, 67% plan to allocate 6-10% of their fixed income portfolio to ETFs.

Non-users point to reasons why they are not current using ETFs – investment guidelines not allowing ETFs, lack of understanding about liquidity and all-in costs, and low levels of sell-side coverage. Greenwich sees the barriers to adoption will “inevitably weaken” as ETF use continues to gain momentum.

Daniel Gamba, Head of iShares Americas Institutional Business at BlackRock, says: “The Greenwich report’s findings represent many of the conversations we have with institutions. They are making numerous portfolio changes and struggling with a more challenging bond market, which makes them open to using new investment tools.

“We help educate them on ETF liquidity, costs and how to use them. Perhaps because of changes to the underlying market, we see that once institutions use fixed income ETFs, they quickly embrace them as important strategic tools.”

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