Institutional investors bond over fixed-income ETFs

European institutional investors are using exchange-traded funds to position themselves in high-yield and emerging markets bonds ahead of expected interest rate hikes

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ETFs providing alternatives to over-the-counter bonds

Exchange-traded fund (ETF) providers are cheering the growing use of bond ETFs as European institutional investors seek cheaper and more liquid alternatives to over-the-counter bonds.

ETFs tracking high-yield and emerging markets bonds are proving popular for sophisticated investors looking to maintain their fixed-income exposure while avoiding a mark-to-market hit when interest rates rise.

But there is growing awareness among ETF issuers of the challenges and risks that come from providing intraday liquidity to pools of assets that change hands in relatively illiquid OTC markets.

Fixed-income exchange-traded products (ETPs) gathered $14.1 billion in May and have attracted a record $40 billion globally in the year to date, bringing total assets under management to just over $400 billion, according to the May ETP landscape: monthly snapshot report from Blackrock. A broader array of fixed-income offerings and the continued easy money policies of central banks are contributing to this growth, according to the report.

Institutional investors at last week's Inside ETFs Europe conference in Amsterdam said they are using ETFs to bet on bonds because the products are often cheaper to trade than OTC bonds, offer access to diversified baskets of underlyings, and tend to be more liquid than the underlying debt.

Where institutions lack in-house expertise in certain assets, they can use ETFs to access those markets, said Arnaud Llinas, Paris-based head of ETFs and indexing at Lyxor. "Institutions may not have the in-house capacity to analyse emerging markets or high-yield bonds, so they decide to invest in global benchmarks through ETFs."

But there was a difference of opinion among investors at the conference about how to position themselves ahead of an expected rise in interest rates as the US Federal Reserve tapers its asset purchase programme, which is expected to negatively affect bond prices.

Issuers such as Deutsche Asset and Wealth Management have begun offering products like short-duration, interest rate-hedged and short-bond ETFs in Europe. "Over the past year, we've expanded our product range to deal with [interest rate sensitivity], and so have our competitors," said Arne Noack, head of exchange-traded product development for Europe, the Middle East and Africa (Emea) at Deutsche Asset and Wealth Management in London.

Institutional investors at the conference said they had sold their traditional core fixed-income holdings and bought non-core bonds such as high-yield and emerging markets debt because of the resiliency those assets have historically shown during periods of rising rates.

Michael Jones, chairman and chief investment officer of RiverFront Investment Group in Richmond, Virginia, said his firm had sold off most of its fixed-income exposure, leaving "a lot of short maturity corporates and short maturity high-yield corporates."

Sacha Widin, Zurich-based head of wealth management funds at Credit Suisse Asset Management, said he sees more value in emerging markets bonds. "In almost all periods of rising 10-year swap rates, so-called non-core and non-traditional bonds performed quite nicely, but not traditional bonds – there, you lost performance."

Though there has not yet been a serious blow-up in an ETF tracking credit, issuers are aware that a liquidity mismatch between an ETF and its underlying assets could pose dangers. "Fixed income is an OTC world and we are providing intraday, visible liquidity to something that is not as liquid and not as visible," said Lyxor's Llinas. "It could be dangerous if we don't pay attention to the liquidity match between what we offer through the ETF and what the underlying assets can support."

However, Leen Meijaard, head of Emea sales at iShares in London, called fixed-income ETFs "the big opportunity" in Europe. "Due to regulatory developments and bank capital requirements, [investment banks have decreased their role in providing bond liquidity]. ETFs are creating secondary market liquidity in bonds for institutions."

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