Interest in fixed income exchange-traded funds (ETFs) is growing. The average percentage of investors’ portfolios invested in bond ETFs is expected to rise from 7% to 12% within three years, a recent study by Tabula Investment Management found. But despite this increasing popularity, the investment vehicle can often be misunderstood.
When there is market volatility, the vehicle gets a lot of interest from the financial press and investors, says VanEck’s head of fixed income ETF portfolio management, Francis Rodilosso.
“ETFs are what you might look at if you want to know how credit markets are doing intra-day or how volatile they have been – ETFs are a good vehicle to see how it’s going, but there’s a difference between being a symptom of the problem or a cause of the problem,” he tells Funds Europe.
According to the fixed income manager, ETFs are a primary source of information for whatever is going on in the market. But when things aren’t going well, it can give ETFs the image that they are leading the volatility.
“People concerned about ETFs, or who might hold the notion that ETFs are going to lead to some kind of calamity, ignore the fact that these are generally very straightforward, very transparent non-leveraged structures,” says Rodilosso.
A common criticism he hears is that, in periods of stress, the secondary market in bonds breaks down and the promise of liquidity in ETFs is false and will cause a blow-out. However, he notes that the fourth quarter last year provides an example of the ETF dynamic and what can happen in stressed periods.
“Credit spreads moved wider pretty rapidly, and fairly significantly, from just over 300 basis points over treasuries on US high yield to well over 500 basis points during the fourth quarter. Secondary market trading volume in cash bonds fell precipitously during this time. But, importantly, trading volume in fixed income ETFs, including high yield bond ETFs, accelerated,” he says.
“ETFs actually became liquidity vehicles. They also became price-discovery mechanisms and had various other uses: people hedging exposure, people wishing to reduce their overall exposure to high yield and had ETFs as part of their high yield allocation, people looking to add exposure were willing to provide bids, add exposure tactically, or strategically.”
When the trading price of ETFs relative to their net asset value moved into discount territory, the next criticism would be that investors aren’t getting the same liquidity, because the price of high yield ETFs has slipped below net asset value, he says.
A fund’s valuation is based on an estimation by pricing services of where market prices are for cash bonds. “But if cash bonds aren’t trading a lot, then that net asset value can become stale or slow to react, and the ETFs themselves become the better measure of where prices are.”
Much of the criticism of fixed income ETFs, says Rodilosso, comes from active managers.
Read Funds Europe’s November report on fixed income ETFs here.
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