The revolutionary impact of ETFs on bond markets

Fixed income ETFs have seen exponential growth for more than a decade, driven by the way ETFs have modernised the fixed income market and democratised the way in which investors gain exposures to fixed income instruments, Alex Zaika writes. 

Since their debut 15 years ago, fixed income exchange traded funds (ETFs) have changed the way that investors access the fixed income market. Investors can not only gain exposures to different bonds in different regions, but can also achieve investment diversification and cost efficiency at the same time – all by just investing in one single ETF. 

 

ETFs: an innovative investment

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Shipping containers were invented in 1956 and transformed global trade by streamlining the shipping transport process with a uniform container to replace a process which had previously been slow and inefficient. 

By the same token, ETFs are a structure that packages up individual securities and makes them available on an exchange. By “packaging up” financial assets into one structure, ETFs significantly improve the efficiency of the investment process by enabling multiple capital market exposures available in the one “container” on an exchange. 

These innovative financial instruments have multiple benefits with some features particularly apparent in fixed income ETFs (bond ETFs). For instance, the additional layer of liquidity that they create.

The additional layer of liquidity offered by bond ETFs is a major driver of their remarkable growth. Traditional bonds are mostly traded over-the-counter (OTC) by larger and more sophisticated investors, making it difficult for retail investors to enter and access the market. Size and scale mattered – from trade execution to getting allocations for new issues – investors would need a high level of financial knowledge to fully comprehend the underlying cost and mechanism when trading individual bonds. 

However, trading on the exchange creates liquidity and allows for bond ETFs to be used to manage risk and adjust market exposures. Instead of trading one single bond in the OTC market, investors are effectively trading a portfolio of bonds at a visible and transparent price on the exchange and thus diversifying their portfolios while trading bonds exactly like stocks. By creating this venue for investors to trade and express their views, ETFs create an additional layer of liquidity that can often lead to the ETF being a lot more cost efficient to trade than the underlying basket of bonds.

 

Obtaining precision exposures with ETFs

Bond ETFs also enable investors to gain precision exposures within the fixed income market. Before the emergence of ETFs, many investors relied on active mutual funds or individual securities to access such markets and did not only have to know the ins and outs of the desired security, but they also had to find active fund managers who shared similar investment philosophies as they did.

However, with bond ETFs, investors can construct their portfolios, follow asset allocation guidance, or express their own tactical or strategic views in a low-cost and efficient manner. An investor can better manage their portfolio risk in the sense that investors seeking exposures to high yield bonds know that the equivalent ETF will only hold these assets in the underlying basket. Investors know what they are invested in – and what they would not be.

The market for bond ETFs has grown for more than 15 years and allowed investors to easily access the fixed income market without going through the OTC market, providing a more cost efficient channel for investors looking to add bonds to their portfolios. 

This is especially relevant given Australian investors are underweight fixed income relative to global allocations.

Fixed income ETFs make up less than one per cent of the world’s fixed income market but if the growth of equity ETFs was any indication, bond ETFs could continue to grow at double digits and reach over $3 trillion in the next five years.  

 

Alex Zaika is head of wealth at BlackRock’s iShares Australia.




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