The Guide to Fixed Income ETFs
EXCHANGE TRADED FUNDS FOR FIXED INCOME INVESTORS Since iShares launched the first US fixed income exchange traded funds (ETFs) in 2002, ETFs have become an increasingly important part of global bond markets. Initially viewed as bond access vehicles for smaller investors, fixed income ETFs are now being used more frequently by larger, more sophisticated institutional investors. This trend accelerated in the aftermath of the 2008 financial crisis as fixed income markets grew in complexity. Despite record bond issuance, new regulations have resulted in lower dealer inventories, thus driving down trading volumes and liquidity for individual bonds. Meanwhile, investors have become more familiar with trading fixed income ETFs. Many fixed income ETFs have developed a robust level of on-exchange and over-the-counter (OTC) liquidity, supplementing the underlying bond market. Increasingly, institutional investors are turning to fixed income ETFs for their flexibility, liquidity, cost-effectiveness and exchange tradability.
iShares fixed income ETFs
Global fixed income ETF industry AUM1
Industry number of fixed income ETFs1
$496bn
897
[2] THE GUIDE TO FIXED INCOME E TFs
Despite significant growth over the last decade, the fixed income ETF market remains small when compared to the cash bond and mutual fund markets. However, we believe assets in fixed income ETFs could reach $2 trillion globally over the next decade. As a pioneer of fixed income ETFs, BlackRock continues to drive the industry’s innovation, from introducing the first investment grade corporate, government, high yield corporate and emerging market ETFs, to offering flagship products that have experienced tremendous growth in assets and trading volume. As such, we have created The Guide to Fixed Income ETFs, the first dedicated resource for investors interested in using ETFs in their fixed income portfolios.
Brett Olson
Brett Pybus
BlackRock’s Head of Fixed Income iShares EMEA
BlackRock’s Head of iShares EMEA Fixed Income Product Strategy
1. Source: BlackRock, as at 31.12.2015.
iShares share of total ETF industry trading volume1
10-year growth rate in fixed income ETF assets1
10-year growth rate in fixed income ETF trading volume1
65%
39%
42% THE GUIDE TO FIXED INCOME E TFs [3]
EXECUTIVE SUMMARY
1
TABLE OF CONTENTS SUMMARY
2
INTRODUCTION
6
CHAPTER 1: BENEFITS OF iSHARES FIXED INCOME ETFs
12
–– FLEXIBILITY
16
–– LIQUIDITY
18
–– COST-EFFECTIVENESS
20
–– EFFICIENCY
22
CHAPTER 2: ETF PRICING AND MECHANICS
24
–– CREATION/REDEMPTION PROCESS
26
–– UNDERSTANDING FIXED INCOME ETF PRICE BEHAVIOUR
28
CHAPTER 3: ANALYSING FIXED INCOME ETFs
32
–– COMPARING FIXED INCOME QUOTE CONVENTIONS
34
–– BLOOMBERG FIXED INCOME ETF ANALYTICS
36
CHAPTER 4: iSHARES FIXED INCOME ETF PORTFOLIO MANAGEMENT PROCESS
42
CHAPTER 5: FIXED INCOME ETFs AND INDEX DERIVATIVES
48
–– EXPLORING CREDIT ACCESS VEHICLES
50
–– COMPARING CORPORATE BOND ETFs, TOTAL RETURN SWAPS AND CREDIT DEFAULT SWAPS
[4] THE GUIDE TO FIXED INCOME E TFs
52
CHAPTER 6: COMMON INSTITUTIONAL APPLICATIONS
56
–– CASH AND LIQUIDITY MANAGEMENT
60
–– NICHE MARKET ACCESS
64
–– TACTICAL ASSET ALLOCATION
66
–– TRADING TOOLS
67
–– PORTFOLIO CONSTRUCTION TOOLS
68
–– TRANSITION MANAGEMENT
72
CHAPTER 7: FIXED INCOME ETF MARKET STRUCTURE DEVELOPMENTS
76
–– FIXED INCOME ETF UNIT LENDING
78
–– ETFs AS ACCEPTABLE COLLATERAL
80
–– DERIVATION OF FIXED INCOME RISK METRICS
82
CHAPTER 8: TAX CONSIDERATIONS FOR INSTITUTIONAL INVESTORS
86
–– THE THREE LEVELS OF TAX
88
–– TAXES ON ETF DISTRIBUTIONS FOR FIXED INCOME ETFs
90
WHY iSHARES?
92
–– iSHARES INVESTMENT STRATEGY AND INSIGHTS
96
–– iSHARES CAPITAL MARKETS TEAM
98
–– INSTITUTIONAL REPORTING
104
–– ADDITIONAL RESOURCES AVAILABLE FROM iSHARES
106
–– iSHARES ETF INDEX COVERAGE ACROSS FIXED INCOME
108
–– iSHARES FIXED INCOME ETF PRODUCT LIST
110
THE GUIDE TO FIXED INCOME ETFs [5]
TABLE OF CONTENTS
1
FIXED INCOME ETFs: THE BASICS European domiciled fixed income ETFs are typically managed under UCITS directives while US fixed income ETFs are typically 1940 Act funds. In both instances, the ETFs consist of a portfolio of bonds and are traded on an exchange like an equity security as well as OTC. iShares fixed income ETFs are generally fully funded, unlevered vehicles that hold cash bonds. Most fixed income ETFs track market indices that follow targeted segments of the markets, such as government, investment grade corporate, high yield corporate or emerging market bonds. Rather than trading fixed income through the OTC bond market, investors can access these exposures on an exchange, which may lower the cost of trading and at the same time improve price transparency. Institutional investors use fixed income ETFs as core long-term investment holdings, as tools for targeting precision exposures and as financial instruments that serve as substitutes or complements to derivatives.
2002
2003
2003
JUL
MAR
MAY
iShares launches the first fixed income ETF
iShares launches the first Euro investment grade corporate bond ETF in Europe
iShares launches the first $ investment grade corporate bond ETF in Europe
[6] THE GUIDE TO FIXED INCOME E TFs
INTRODUCTION
1
FIXED INCOME ETFs
PRIMARY USES
BOND ETF FEATURES
EXCHANGE LISTED LIKE AN EQUITY CORE INVESTMENTS PRECISION EXPOSURES FINANCIAL INSTRUMENTS
DIVERSIFIED LIKE A PORTFOLIO OF BONDS
2003
2004
2006
SEP/DEC
DEC
JAN
iShares launches first aggregate bond ETF and first TIPS ETF in the US
Fixed income ETF industry reaches US$10bn
First iShares UK Gilt ETF launched in Europe
THE GUIDE TO FIXED INCOME ETFs [7]
GROWTH IN FIXED INCOME ETFs HAS ACCELERATED SINCE 2008 The global fixed income ETF market is quickly becoming an integral part of the fixed income landscape, with the liquidity crisis of 2008 serving as a catalyst. There has been a continued increase in the adoption of fixed income ETFs, driven by the growth in ETF fund size and breadth of the offered exposures, combined with the added on-exchange and OTC liquidity. A wide cross section of investors, including asset managers, insurance companies and pension funds, are now pioneering new investment approaches using ETFs to gain fixed income exposure.
2006
2006
2007
FEB
DEC
APR
First iShares $ Treasury bond ETF launched in Europe
Fixed income ETF industry reaches US$36bn
iShares launches first high yield bond ETF
[8] THE GUIDE TO FIXED INCOME E TFs
INTRODUCTION
GLOBAL FIXED INCOME ETF AUM IS NEARLY $500 BN 500
TOTAL AUM $BN
400
300
200
Assets have climbed 479% since 2008 as investor adoption has increased and usage has broadened
100
0
01
02
03
04
05
06
07
Broad/aggregate
08
09
10
11
Investment grade corporate
Government and municipal Inflation-linked
Govt/corp
Money market
12
13
14
15
Emerging markets High yield corporate Mortgage
Others
Source: BlackRock, Bloomberg, Barclays, as at 31 December 2015. Govt/corp refers to treasuries, agencies, quasi-federal corporations, corporate or foreign debt guaranteed by the US government, US corporate and foreign debentures and secured notes.
2007
2008
2008
DEC
FEB
DEC
Fixed income ETF industry now has over 150 ETFs
iShares launches first emerging markets hard currency ETF in Europe
Fixed income ETF industry reaches US$100bn
THE GUIDE TO FIXED INCOME E TFs [9]
A NEED FOR SOLUTIONS AS BOND MARKET LIQUIDITY HAS DECLINED Investors face a number of liquidity challenges in the corporate bond market. Liquidity, measured by both trading volumes and average trade size, has been declining since 2007. At the same time, the 2008 financial crisis and subsequent reforms led to a reduction in the amount of capital that banks, brokers and other traditional liquidity providers commit to supporting secondary bond trading. This further reduced the tradable supply of bonds, impacting investors’ efforts to both buy and sell specific issues. In addition, the OTC corporate bond market is characterised as a highly fragmented market, whereby dozens or even hundreds of unique securities are issued by the same entity. This fragmentation dilutes security-level liquidity as investors are forced to grapple with myriad bonds from a given issuer with different coupon levels, seniority, call features and maturity dates. As a result, corporate bonds face discontinuous liquidity, where some individual securities trade infrequently, or not at all, during a given month. Measuring this phenomenon in Europe is difficult with lack of trade reporting on bond transactions, however, the US provides the best supporting evidence through its trade reporting mechanism: TRACE.
2009
2010
2010
SEP
MAR
DEC
iShares launches first fixed income ETF in Latin America
iShares launches first Euro high yield corporate bond ETF in Europe
Fixed income ETF industry reaches $200bn
[10 ] T H E G U I D E T O F I X E D I N C O M E E T F s
INTRODUCTION
Since December of 2011, the US high yield corporate bond index has increased by ~130% in terms of market value and ~120% in terms of number of bonds. The US investment grade corporate bond index has increased by 142% in terms of market value and 139% in terms of the number of bonds. While both of these universes have grown with issuance, the frequency of bonds trading daily has decreased. The most notable drop is the investment grade universe, which has fallen from 29.0% in 2013 to 21.0% in 20151. The net impact of these recent challenges has resulted in the rapid increase in fixed income ETF assets. DEALER BOND INVENTORIES HAVE BEEN DECLINING SINCE 2007 250
4,500 4,000
200
3,500
2,500
$BN
$BN
3,000 150
2,000
100
1,500 1,000
50
500 0
2001
2002
2003
2004
2005
2006
2007
Barclays Corp Index Market Value (RHS)
2008
2009
2010
CMBS
Investment grade corporate
2011
2012
RMBS
2013
2014
0 2015
Corporates (before 2013)
High yield corporate
Commerical paper
Source: Federal Reserve Bank of NY, Barclays as at 31 December 2015. 1 Source: BlackRock, TRACE.
2012
2013
2014
APR
DEC
DEC
iShares launches first emerging markets corporate bond ETF in Europe
Fixed income ETF industry now has over 780 ETFs
Fixed income ETF industry reaches $430bn
T H E G U I D E T O F I X E D I N C O M E E T F s [ 11 ]
“
Institutional investors are increasingly using fixed income ETFs as efficient building blocks within broader portfolios; we’re seeing active managers blend ETFs into their portfolios as tools to provide enhanced flexibility.
“
Stephen Cohen BLACKROCK’S CHIEF INVESTMENT STRATEGIST FOR INTERNATIONAL FIXED INCOME AND iSHARES
BENEFITS OF iSHARES FIXED INCOME ETFs
1
BENEFITS OF iSHARES FIXED INCOME ETFs The Guide to Fixed Income ETFs will detail a number of the facets of ETFs, however, the key benefits of these products can be summarised by the following four key attributes:
1
FLEXIBILITY
2
LIQUIDITY
ETFs PROVIDE A VARIETY OF BROAD AND TARGETED EXPOSURES.
ETFs MAY OFFER AN ADDITIONAL SOURCE OF LIQUIDITY FOR FIXED INCOME INVESTORS.
[14] T H E G U I D E T O F I X E D I N C O M E E T F s
3
COST-EFFECTIVENESS
4
EFFICIENCY
ETFs MAY PROVIDE FIXED INCOME INVESTORS WITH SIGNIFICANT COST SAVINGS.
ETFs HELP OVERCOME THE CHALLENGES IN THE OTC MARKET.
T H E G U I D E T O F I X E D I N C O M E E T F s [15 ]
BENEFITS OF iSHARES FIXED INCOME ETFs
1
ETFs ENABLE A VARIETY OF BROAD AND TARGETED EXPOSURES FLEXIBILITY ETFs enable investors to gain broad market exposure in a single trade, or create highly customised solutions by targeting specific fixed income sectors. Investors may quickly increase or decrease exposures to target sectors more precisely and efficiently through ETFs than could otherwise be accomplished using the underlying OTC bond or derivative markets. The instantaneous diversification, targeted long and short exposures and lending opportunities provided by fixed income ETFs add flexibility to even the most sophisticated investors.1 iShares offers over 85 European domiciled fixed income ETFs including government, investment grade corporate, high yield corporate and emerging market bonds.2
1. With short sales, an investor faces the potential for unlimited losses as the security’s price rise. Also note that the lending market in EMEA is still emerging. 2. Source: BlackRock. Data as at 31 December 2015.
[16] T H E G U I D E T O F I X E D I N C O M E E T F s
DISAGGREGATING THE GLOBAL BOND UNIVERSE WITH iSHARES
Government
Over 45 EMEA domiciled government bond ETFs across a range of maturities. These include global, regional, single country and emerging market debt exposures.
Over 20 EMEA domiciled investment grade corporate bond ETFs across a range of currency and maturity profiles.
Investment grade 13.9% 4.0% 5.0%
Global bond universe
Inflationlinked
61.2%
4 EMEA domiciled inflation-linked bond ETFs.
15.9%
High yield
Securitised High yield Inflation-linked Investment grade Government
Securitised
6 EMEA domiciled high yield corporate bond ETFs.
2 EMEA domiciled ETFs providing exposure to covered bonds and Pfandbriefe.
Source: Global Bond Universe data sourced from Barclays Point: Barclays Multiverse index and Barclays Inflation Linked index universes. iShares data sourced from BlackRock.
T H E G U I D E T O F I X E D I N C O M E E T F s [17 ]
BENEFITS OF iSHARES FIXED INCOME ETFs
1
ETFs OFFER AN ADDITIONAL SOURCE OF LIQUIDITY FOR FIXED INCOME INVESTORS LIQUIDITY The growth of the fixed income ETF market has helped create a new, incremental source of liquidity for investors, above and beyond what can be accessed in the OTC market. Fixed income ETFs effectively provide an additional trading venue – the exchange – where shares can be transferred among investors without accessing the underlying OTC bond market. In this way, ETFs act as an additional layer of liquidity for investors seeking bond exposure. Through a unique set of circumstances – the financial crisis, the US Treasury downgrade and the tapering of quantitative easing – fixed income ETF liquidity globally has increased relative to the OTC bond market. Since the beginning of 2008, trading volume has grown more than 700% as investors have turned to ETFs in times of stress.1 Today, trading in fixed income ETFs averages US$4.4bn per day and iShares ETFs represent nearly 69% of total ETF trading volume globally.2
1. Source: BlackRock. Data as at 31 December 2015. 2. Source: BlackRock. Data as at 31 December 2015.
[18] T H E G U I D E T O F I X E D I N C O M E E T F s
BENEFITS OF iSHARES FIXED INCOME ETFs
1
A SECOND LAYER OF FIXED INCOME LIQUIDITY
MONTHLY TRADING VOLUME ($BN)
160
120
80
40
0
Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 08 Dec 09 Dec 10 Dec 11 Dec 12 Dec 13 Dec 14 Dec 15 Total ETF industry trading volume
iShares total trading volume
There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. Source: BlackRock and Bloomberg, as at 31 December 2015.
T H E G U I D E T O F I X E D I N C O M E E T F s [19 ]
ETFs MAY PROVIDE BOND INVESTORS WITH SIGNIFICANT COST SAVINGS COST-EFFECTIVENESS iShares ETFs generally offer price improvement, making secondary market ETF trades less expensive than trading the underlying bonds of the respective index. Relative to a basket of bonds, ETFs offer the benefit of on-exchange liquidity, which often results in lower transaction costs. As illustrated on the opposite page, the bid/offer spread of many fixed income ETFs is tighter than their underlying bond baskets.
[20] THE GUIDE TO FIXED INCOME E TFs
ETFs MAY OFFER THE POTENTIAL FOR PRICE IMPROVEMENT 120
100
105
85
BASIS POINTS
80
75
60 45
40
35
25
20 15.0 0
18.0 10.0
5.5
11.0
3.5
iShares J.P. Morgan iShares $ Corp iShares $ High Yield iShares Core € iShares Euro iShares € Aggregate $ EM Bond UCITS ETF Bond UCITS ETF Corp Bond UCITS Corp Bond UCITS High Yield Bond Bond UCITS USD (Dist) USD (Dist) ETF USD (Dist) ETF EUR (Dist) UCITS ETF EUR (Dist) ETF EUR (Dist) (IEMB) (LQDE) (IHYU) (IEAC) (IHYG) (IEAG) Primary bid/offer spread
3 month average bid/offer spread on-exchange with highest ADV
Source: BlackRock, Bloomberg. Data as at 31 December 2015.
T HE G U ID E T O F I X ED IN C O ME E T F s [21]
BENEFITS OF iSHARES FIXED INCOME ETFs
1
ETFs HELP OVERCOME THE CHALLENGES IN THE OTC MARKET EFFICIENCY Much of the cost savings that fixed income ETFs offer arises from the fact that fixed income ETFs can trade in the secondary market (both on and off exchange) without causing any trading of the underlying instruments. This allows for efficient trading, which alleviates many of the impediments caused by dislocations in the markets. The OTC bond markets create a number of challenges for bond investors. First, it is difficult to determine best execution. An investor can solicit market bids or offers from a selection of dealers, but that investor has no way of knowing whether they executed at the best available price in the market. Second, OTC bond markets generally provide either the bid or offer price for a transaction, making it difficult to directly observe trading spreads. Finally, specific issues can be difficult to find as lower dealer inventories and the fragmented nature of the bond market make sourcing bonds operationally intensive.
[22] THE GUIDE TO FIXED INCOME E TFs
OTC BOND MARKETS
EXCHANGE MARKETS
(FRAGMENTED MARKETPLACE)
(CENTRALISED MARKETPLACE)
EXCHANGE
BROKER
INVESTOR
In contrast to bonds, fixed income ETFs are traded both on centralised exchanges such as the London Stock Exchange as well as OTC. Through the exchange, investors can easily see execution prices throughout the trading day. Unlike the OTC bond market, on-exchange trading provides a high level of visibility into trading volumes, two-sided market levels (both bid and offer) and transaction costs. It also offers investors more control over trade execution by allowing them to execute limit, stop loss and short orders. Fixed income ETFs bring efficiency and transparency to bond trading, allowing investors to transact bonds as easily as listed equity securities.
THE GUIDE TO FIXED INCOME E TFs [23]
BENEFITS OF iSHARES FIXED INCOME ETFs
1
“
In a bond market that is changing profoundly across the globe with liquidity more and more scarce, fixed income ETFs offer institutional investors an additional vehicle to express their broad views in a transparent and cost effective manner.
“
Leland Clemons BLACKROCK’S HEAD OF CAPITAL MARKETS AND INVESTMENT STRATEGY, iSHARES
ETF PRICING AND MECHANICS
2
CREATION/REDEMPTION PROCESS OF FIXED INCOME ETFs The supply of fixed income ETF shares is determined by a unique mechanism called the creation/redemption process. Broker-dealers who create or redeem shares of ETFs are known as Authorised Participants (APs). APs generally work with both investors and ETF providers to maintain liquidity in the market.
THE CREATION/REDEMPTION PROCESS IN ACTION
INVESTOR/ BUYER ETF shares
Investor purchases a fixed income ETF listed on an exchange
For illustrative purposes only.
[26] THE GUIDE TO FIXED INCOME E TFs
TWO SOURCES OF LIQUIDITY TO FILL ORDER
Cash
BROKER-DEALER AUTHORISED PARTICIPANT
BEHIND THE SCENES
1
2
Behind the scenes, an AP can fill or partially fill the order with:
When strong buying demand occurs, an AP can fill the order with available inventory, often resulting in tighter bid/offer spreads for the investor versus buying the individual bonds in the respective index. If ETF inventory becomes depleted, APs will purchase a subset of the underlying bonds in the OTC market and deliver these securities in-kind to BlackRock, which will then create new ETF shares. The AP will then deliver the shares to fill outstanding client orders. The ability for investors to utilise an ETF’s on-exchange liquidity may result in much tighter bid/offer spreads than would generally be possible through the OTC bond market.
ON-EXCHANGE ETF LIQUIDITY
OTC BOND MARKET LIQUIDITY
In-kind delivery of underlying portfolio basket
1. Existing ETF liquidity on the exchange market and/or 2. Gathering the bonds that make up the ETF in the OTC bond market and transferring them in-kind to BlackRock, thereby creating new ETF shares and delivering them to the AP.
THE GUIDE TO FIXED INCOME E TFs [27]
ETF PRICING AND MECHANICS
2
UNDERSTANDING FIXED INCOME ETF PRICE BEHAVIOUR The price at which an ETF trades is primarily a function of the value of the underlying securities in the portfolio. It is also influenced by market flows, liquidity and market volatility. The net asset value (NAV) of an ETF is equal to the total fund assets divided by the total shares outstanding. When an ETF trades at a price above the NAV, it is said to be trading at a premium; when the ETF is trading below the NAV, it is said to be trading at a discount. The NAV of a fixed income ETF is calculated using the bid side prices for the underlying bonds in the ETF as of the end of the day1. The market price of the ETF will generally fluctuate between the bid and offer price of the underlying bonds as the ETF trades through the day. Under most market conditions, a fixed income ETF will trade at a premium to (above) this bid-side NAV to reflect a market clearing price for the fund. During periods of strong demand for an ETF, the price is bid up in the market. If the ETF price is sufficiently higher than the value of the underlying securities held within the ETF, an arbitrage opportunity may exist. Authorised Participants could purchase the underlying fixed income securities, deliver them to the ETF provider in exchange for new ETF shares (create new shares) and then sell the newly created ETF shares in the market for a small profit. The creation of new ETF shares helps balance supply and demand, which brings the NAV and the ETF price back into alignment.
1. Net asset value for ETFs with government bond underlying and certain corporate bonds typically use mid pricing.
[28] THE GUIDE TO FIXED INCOME E TFs
ETF PRICING IN A BALANCED MARKET ETF creation cost ETF premium to NAV
Portfolio bid (NAV)
Portfolio mid-market
Portfolio offer
ETF bid/offer (liquidity layer)
ETF PRICING WITH STRONG BUY DEMAND ETF creation cost ETF premium to NAV Buying pressure Portfolio bid (NAV)
Portfolio mid-market
Portfolio offer ETF bid/offer (liquidity layer)
For illustrative purposes only.
For illustrative purpose only. Although market makers will generally take advantage of differences between the NAV and the trading price of shares of ETFs through arbitrage opportunities, there is no guarantee that they will do so.
THE GUIDE TO FIXED INCOME E TFs [29]
ETF PRICING AND MECHANICS
2
CASE STUDY: HIGH YIELD ETFs IN STRESSED MARKETS During periods of increased market volatility, OTC bond market liquidity generally declines as trading becomes concentrated in a subset of larger and more liquid issues and investors encounter difficulty transacting in less liquid securities. A recent example occurred in December 2015 when there was a big selloff in the US high yield market. The sell-off was sparked by declining oil prices and concerns about energy and commodity companies. Amid this turmoil, all US-listed high yield bond ETFs notched record trading activity, touching US$6 billion in volume on Friday 11 December 2015 alone. ETFs amplified the broader high yield market’s volume of roughly US$21 billion. ETF sellers and buyers were able to easily transact at known, transparent prices on stock exchanges. In yet another real live ‘stress test’ high yield bond ETFs traded without disruptions and helped enhance market liquidity. US high yield ETFs once again showed they may be used to express a view on high yield securities during times of market stress, with US$4.3 billion in trading volume on a representative US high yield corporate bond ETF during Friday 11 December 2015 alone and US$10 billion over the course of the whole week. High yield plays a role in many investment portfolios. Short-term and long-term investors can efficiently buy and sell US high yield ETFs during market hours, even in volatile markets. The behaviour of this ETF during bouts of market stress serves as evidence that ETFs – even in less liquid markets – can be a robust vehicle for managing and transferring risk. It is because of these attributes that liquid fixed income ETFs, such as the example illustrated here, have become key indicators of cash bond market movements.
[30] THE GUIDE TO FIXED INCOME E TFs
IN TIMES OF STRESS, ETFs PROVIDE ACCESS TO ILLIQUID MARKETS A representative USD High Yield Corporate Bond ETF volume as % of trace volume REPRESENTATIVE USD HIGH YIELD CORPORATE BOND ETF VOLUME / TRACE VOLUME (%)
30 25 20 15 10 5 0 Dec 07
Dec 08
Dec 09
Dec 10
Dec 11
Dec 12
Dec 13
Dec 14
Dec 15
EXCHANGE VOLUME TO CREATE/ REDEEM RATIO
A representative USD High Yield Corporate Bond ETF secondary to primary ratio 25 20 15 10 5 0 2007
2008
2009
2010
2011
2012
2013
2014
2015
Source: BlackRock, Bloomberg, as at 31 December 2015. Rolling 20-day average shown for each. Cash bonds are measured by FINRA TRACE Market Breadth High Yield and High Grade Bond Dollar Indices and ETF volume is ADV. The case study references 31 December 2015. Case studies are for illustrative purposes only; they are not meant as a guarantee of any future results of experience. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.
FIXED INCOME ETFs AND THE CORPORATE BOND LIQUIDITY CHALLENGE Access the full whitepaper at iShares.com
T HE G U ID E T O F I X ED IN C O ME E T F s [31]
ETF PRICING AND MECHANICS
2
“
We are increasingly using fixed income ETF pricing dynamics as another indicator of market movements and sentiment. The various tools available to my team now make ETFs an increasingly appealing instrument to implement trading strategies and monitor intra-day market movements.
“
Dan Veiner BLACKROCK’S HEAD OF FIXED INCOME TRADING EMEA
ANALYSING FIXED INCOME ETFs
3
COMPARING FIXED INCOME QUOTE CONVENTIONS Bond market participants quote securities in a variety of ways, including using prices, yields and spreads. Fixed income ETFs are exchange traded and quoted in price terms like equity securities. The following table provides a framework for the interpretation and comparison of individual bond and fixed income ETF quotes.
INSTRUMENT
QUOTE CONVENTION
FIXED INCOME ETFs
Price
INVESTMENT GRADE BONDS
Spread (over government securities and swaps)
HIGH YIELD BONDS
Price or yield
CREDIT DEFAULT SWAPS (ITRAXX)
IG = spread (cost for protection) HY = price or spread (cost for protection)
GOVERNMENT BONDS
Price and yield
FLOATING RATE NOTES
Spread (known as discount margin)
EMERGING MARKET DEBT
Price (yield and spread taken into consideration)
*EUR, GBP, CHF, USD For illustrative purposes only
[34] THE GUIDE TO FIXED INCOME E TFs
UNITS
QUOTE EXAMPLE (BID/OFFER)
Currency*
€114.76/€114.77
Basis points
137/131
Currency* or percentage points
€103.090/€103.909 or 6.509/6.317
IG = basis points HY = currency and basis points
IG = 58.823/58.269 HY = €107/€107.125 or 308.76/306.453
Currency* and percentage points
€96.228/€96.335 and 1.924/1.914
Basis points
62/58
Currency*
€99.25/€99.75
ANALYSING FIXED INCOME ETFs
3
THE GUIDE TO FIXED INCOME E TFs [35]
BLOOMBERG FIXED INCOME ETF ANALYTICS Analysing iShares fixed income ETFs is possible across multiple platforms, one of which is Bloomberg which supports market participants across the investment process.
GENERAL ETF PAGES EXTF
Bloomberg ETP home page
ETF
Bloomberg ETF home page
NI ETFs
ETF News Feed
DES
ETF Descriptive page
QM
Quotes / Market Share of traded exchanges
IOIA
Indication of interest and dealer axes
HP
Historical price and yield or volume / value traded
DVD
ETF Dividend History
SI
Short Interest
ISHA
iShares ETP home page
[36] THE GUIDE TO FIXED INCOME E TFs
KEY ANALYTICS TOOLS TRA
Calculate return on ETFs using the price, commissions and reinvestment rate using both trade price and NAV When comparing an ETF to an index it is best to compare on a NAV basis; alternatively when comparing tradable instruments, for example iTraxx and cash products, it is best to compare on a price basis
NAV
Historic graph of ETF premium/discount trading Creation/redemption amounts in notional millions
COMP
Evaluate and graph ETF versus index being tracked
IVAT
Visual time series analysis to identify whether prices are historically high or low
CSHF
Analyse projected and past bond payment schedule of the underlying bond holdings
PORT
Portfolio analysis of the underlying bond holdings
BETA
Graph correlation historical sensitivity of ETF to a selected benchmark
YAS
Yield calculator, providing spread to government benchmark, swaps and basis to iTraxx Main and Crossover on selected ETFs
THE GUIDE TO FIXED INCOME E TFs [37]
ANALYSING FIXED INCOME ETFs
3
BLOOMBERG YAS FUNCTION BLOOMBERG The Bloomberg Yield and Spread analysis (YAS) tool enables users to analyse yield, spread and interest rate sensitivity. Originally developed for individual bonds, YAS has been enhanced for analysing select iShares ETFs. Using YAS, Bloomberg users can: `` Analyse a fixed income ETF the same way single bond instruments are analysed `` View a last-traded ETF price, converted to yield `` Perform traditional yield analysis versus a selected benchmark `` Input custom parameters to analyse the relationship between price, yield and spread `` Measure risk based on custom inputs to determine if an ETF meets pre‑determined investment criteria
[38] THE GUIDE TO FIXED INCOME E TFs
The list of ETFs available for YAS analysis is available on the EXTF page:
EXTF +
GO
8+
GO
7+
GO
THE GUIDE TO FIXED INCOME E TFs [39]
ANALYSING FIXED INCOME ETFs
3
ANALYSING AN iSHARES FIXED INCOME ETF WITH YAS FUNCTION
1
Input an iShares ticker from the list:
IHYG +
EQUITY +
YAS +
GO
iShares ticker
Bloomberg command
Bloomberg function
Enter
2
The ETF’s last-traded price is displayed, with corresponding yield, spread and risk characteristics.
3
Modify spread, price or yield fields to identify target ETF trading price, then press .
[4 0] THE GUIDE TO FIXED INCOME E TFs
FOR FURTHER YAS CUSTOMISATION, MODIFY: Maturity year, ticker and coupon of the benchmark bond using the
VS. FIELD
Curve from which the benchmark bond is selected using the
G-SPRD FIELD
Swap curve from which the benchmark is selected using the
I-SPRD FIELD
CDS spread using the
BASIS FIELD
T H E G U I D E T O F I X E D I N C O M E E T F s [ 41 ]
ANALYSING FIXED INCOME ETFs
3
“
Portfolio managers at BlackRock aim to deliver superior index tracking outcomes through a disciplined and pragmatic approach focused on managing return, risk and cost.
“
Michael Harper, CFA BLACKROCK’S HEAD OF EMEA FIXED INCOME PORTFOLIO SOLUTIONS WITHIN MODEL-BASED FIXED INCOME
iSHARES FIXED INCOME ETF PORTFOLIO MANAGEMENT PROCESS
4
iSHARES FIXED INCOME ETF PORTFOLIO MANAGEMENT PROCESS In most instances, the primary goal of an ETF is to track the fund’s designated benchmark. A common misconception is that all ETFs are managed by simply holding each security in the respective benchmark index. In reality, holding every security in the benchmark is nearly impossible in less liquid, OTC bond markets. To solve this issue, many fixed income ETFs employ some form of optimisation or sampling. iShares portfolio managers aim to construct ETF portfolios that are diversified whilst minimising sources of performance drag, such as transaction costs. The index portfolio management process seeks to balance the marginal contribution to tracking error with transaction costs.
[4 4] THE GUIDE TO FIXED INCOME E TFs
BALANCING TRACKING ERROR AND COSTS transaction costs
BASIS POINTS
tracking error
optimal portfolio
NUMBER OF ISSUES Source: BlackRock. For illustrative purpose only.
THE GUIDE TO FIXED INCOME E TFs [45]
iSHARES FIXED INCOME ETF PORTFOLIO MANAGEMENT PROCESS
4
iSHARES FIXED INCOME ETF PORTFOLIO MANAGEMENT PROCESS CONTINUED When full replication is not practical, portfolio managers may employ a stratified sampling strategy. This approach seeks to deliver index risk and return characteristics by holding a subset of securities. Each index is first divided into groups of bonds, which we will call cells, with specific risk factors such as maturity, country, credit rating or sector. Next, representative bonds from each cell are selected to balance liquidity, transaction costs and overall portfolio tax efficiency. Most fixed income indices are rebalanced monthly to take into account the cash flows inherent in fixed income securities and any bonds that enter or exit the index. Portfolio managers receive the forward index from the index provider a few days prior to month-end, allowing them to adjust portfolios to match the new index weights. Since the portfolios are sampled, the funds are not forced sellers or buyers of securities during the rebalancing process. The portfolio managers have discretion as to which bonds to include in the funds. Fixed income indices are rebalanced monthly to account for: `` New issuance
`` Calls or refinancing
`` Maturities
`` Coupon payments
`` Bonds no longer in the maturity range of the index
`` Defaults, downgrades or upgrades
[46] THE GUIDE TO FIXED INCOME E TFs
SAMPLING AN INDEX
MATURITY
SECTOR
1 2 3
CELL BBB rated Industrial 7-10 years maturity
Source: BlackRock. For illustrative purpose only.
The diagram above demonstrates stratified sampling for an investment grade corporate bond ETF. The portfolio management process is ongoing and must account for changes in index composition and asset levels in the funds.
T HE G UID E T O F I X ED IN C O ME E T Fs [47 ]
iSHARES FIXED INCOME ETF PORTFOLIO MANAGEMENT PROCESS
4
“
Fixed income investors are viewing fixed income ETFs as another tool that can be used to express a view, or gain efficient exposure to fixed income beta alongside cash bonds or synthetic instruments such as CDX or iTraxx and total return swaps.
“
Fergus Slinger
BLACKROCK’S CO-HEAD OF iSHARES EMEA SALES
FIXED INCOME ETFs AND INDEX DERIVATIVES
5
EXPLORING CREDIT ACCESS VEHICLES Investors may gain credit exposure through a variety of means, including cash bonds, credit default swaps (CDS/CDX/iTraxx), total return swaps (TRS) and ETFs. Institutional investors who receive large inflows of cash are faced with access, liquidity and timing issues related to their investments. Delays in full allocation may create yield drag and tracking error. Alternatively, institutions may need to hedge credit positions as they attempt to shift allocations or alter risk profiles. Each of these credit access vehicles offers unique attributes, giving investors choice and flexibility in their investment approach. An investor’s preference for one approach over another is a function of the following considerations: `` Desire for cash or synthetic exposure `` Preference of interest rate versus credit spread composition `` Leverage and liquidity requirements `` Direction (long vs. short) `` Holding period `` Operational, accounting and regulatory considerations `` Relative cost of each vehicle
[50] THE GUIDE TO FIXED INCOME E TFs
EXCHANGE TRADED FUNDS (ETFs)
TOTAL RETURN SWAPS (TRS)
CREDIT DEFAULT SWAPS (CDS/CDX/ ITRAXX)
`` Exchange traded fixed income portfolios are generally designed to track specified indices `` Increasing rates of adoption and liquidity
`` OTC swap products designed to pay the total return on specified credit indices `` Generally lower levels of liquidity and higher transaction costs (strike premiums and bid/offer spreads) relative to CDX/iTraxx and ETFs
`` Derivative contracts designed to target credit spreads `` Most liquid and actively traded credit products `` Significant differences in performance versus cash bonds can arise for sustained periods of time
T H E G U I D E T O F I X E D I N C O M E E T F s [ 51]
FIXED INCOME ETFs AND INDEX DERIVATIVES
5
COMPARING CORPORATE BOND ETFs, TOTAL RETURN SWAPS AND CREDIT DEFAULT SWAPS TOTAL RETURN SWAPS AND CORPORATE BOND ETFs Corporate bond ETFs and total return swaps (TRS) on Markit iBoxx indices are both used by investors who are seeking to obtain long or short exposure to the investment grade or high yield corporate bond markets. Corporate bond ETFs are portfolios of bonds that trade on-exchange and track a specified benchmark, while iBoxx TRS are synthetic, unfunded derivative index products. An investor’s preference for one product over the other will be a function of desired leverage, the direction of the exposure (long vs. short), holding period, on-demand liquidity requirements, operational constraints and the relative cost and attractiveness of each vehicle in given market conditions. Investors who do not require leverage should evaluate the relative cost and liquidity of corporate bond ETFs versus TRS. Larger corporate bond ETFs with longer track records may offer ample on-exchange liquidity, while TRS liquidity varies depending on participating counterparties and risk appetites. Market impact for larger trades in more liquid corporate bond ETFs can be 10 bps or less, whereas TRS quoted bid/offer spreads are typically between 40-50 bps at initiation. TRS are OTC bilateral contracts, which expose investors to the credit risk of the dealer counterparty, though this risk may be mitigated through the use of margin/collateral requirements. As ETFs are exchange traded, counterparty risk is negligible and there are no collateral requirements. The historical performance of ETFs and TRS has been similar through time.
[52] THE GUIDE TO FIXED INCOME E TFs
cRediT cRediT deFAuLT SWAPS And And coRPoRATe coRPoRATe Bond Bond ETFs eTFs eTFs CREDIT deFAuLT DEFAULT SWAPS SWAPS AND CORPORATE BOND Credit Credit default swaps (CDX/iTraxx) are are unfunded unfunded derivative derivative derivative index index index Credit default default swaps swaps (CDX/iTraxx) (CDX/iTraxx) are unfunded products products that allow investors to to access access levered levered investment investment grade grade grade products that that allow allow investors investors to access levered investment and and high yield credit spreads across across standardised standardised tenors. tenors. tenors.CDX/iTraxx CDX/iTraxx CDX/iTraxx and high high yield yield credit credit spreads spreads across standardised contracts contracts are highly liquid but but trade trade at at a basis to to cash cash cash bonds bonds bonds and and and do do do not not not contracts are are highly highly liquid liquid but trade at aa basis basis to provide provide exposure to interest interest rates. rates. Their Their index index construction construction is is is typically typically typically provide exposure exposure to to interest rates. Their index construction equally equally weighted and limited limited to to a a sub-set sub-set of of issuers issuers compared compared compared to to to the the the equally weighted weighted and and limited to a sub-set of issuers broader broader cash market. broader cash cash market. market. Credit Credit default swap contracts provide provide investors investors with with with the the the ability ability ability to to to Credit default default swap swap contracts contracts provide investors obtain obtain long or short exposure to to credit credit spreads spreads synthetically. synthetically.The The The obtain long long or or short short exposure exposure to credit spreads synthetically. standardisation standardisation and fungibility of of CDX/iTraxx CDX/iTraxx contracts contracts have have have led led led them them them to to to standardisation and and fungibility fungibility of CDX/iTraxx contracts become become the most liquid credit credit exposure exposure vehicles vehicles in in in the the the market. market. market. become the the most most liquid liquid credit exposure vehicles Alternatively, Alternatively, corporate corporate bond bond ETFs ETFs provide provide aa means means to to attain attain bond bond exposure exposure in in aa fully-funded, fully-funded, exchange exchange traded traded format. format. An An investor’s investor’s vehicle vehicle preference preference is is aa function function of of leverage leverage and and liquidity liquidity requirements, requirements, preferred preferred composition composition of of interest interest rate rate versus versus credit credit spread spread exposure, exposure, position position direction direction and and operational, operational, accounting accounting and and regulatory regulatory considerations. considerations. Investors Investors that that can can trade trade derivatives derivatives may may prefer prefer the the inherent inherent leverage leverage provided provided by by unfunded unfunded CDX/iTraxx. CDX/iTraxx. Conversely, Conversely, investors investors who who employ employ fully fully funded funded strategies strategies may may prefer prefer ETFs. ETFs. Performance Performance differences differences (adjusted (adjusted for for interest interest rate rate exposure) exposure) between between corporate corporate bond bond ETFs ETFs and and CDX/iTraxx CDX/iTraxx are are often often driven driven by by changes changes in in the the basis basis between between the the cash cash and and synthetic synthetic credit credit markets. markets. Comparing Comparing Credit Credit ETFs ETFs and and Credit Index Total Total Credit Index Return Swaps Return Swaps
Comparing Comparing Credit Credit ETFs ETFs and and CreditDefault Default Credit Swap Indices Indices Swap
H E U D Ee TTo O TTh he eG Gu uiIid de o FFIiiX xxE eeD d d IiiN n nC ccO o oM m mE ee E eeTTFFss [[[555355]]]
FIXED FIXED INCOME INCOME ETFs ETFs AND AND INDEX INDEX DERIVATIVES DERIVATIVES
5
FIXED INCOME INDEX PRODUCT CONSIDERATIONS CASH-BASED ETFs CONSIDERATIONS
Requires a custodian or broker to execute trades
COSTS
Management fees; brokerage commissions
PRICING
Real-time, intraday on-exchange
ACCESSIBILITY
On-exchange and OTC
TRANSPARENCY
Yes, daily disclosure of fund holdings
MINIMUM TRADE SIZE
1 share
ADDITIONAL RISK
Limited
EXPIRATION / LIQUIDATION
No maturity Trades like an equity Trading counterparty flexibility
AVAILABILITY FOR LENDING ``LENDING INSIDE THE FUND
Yes, not a large revenue source for fixed income
``LENDING OF THE UNITS/ETFs
Yes, however not yet well developed in Europe
LIQUIDITY PROVIDED
Multiple dealers
[5 4] THE GUIDE TO FIXED INCOME E TFs
TOTAL RETURN SWAPS
CDX/ITRAXX
Standard ISDA contracts Counterparty risk
Standard ISDA contracts Counterparty risk
Annual fee, if held to expiration Break fee on notional Rolling cost
Transaction costs Premium
Upon request as OTC
Real-time, intraday on-exchange
OTC / standardised contracts
On-exchange
No
Yes, as transparent as underlying index
Variable on exposure
1 contract
Counterparty risk
Counterparty risk
Fixed term Closing position only via the same counterparty for OTC
Fixed term Trading counterparty flexibility
No
No
No
No
One dealer for OTC, multiple dealers for standardised contracts
Multiple dealers
THE GUIDE TO FIXED INCOME ETFs [55]
FIXED INCOME ETFs AND INDEX DERIVATIVES
5
“
ETFs present an incredibly efficient way to buy and sell market beta, allowing us to put risk on or off and manage our cash positions.
“
James Keenan, CFA
BLACKROCK’S HEAD OF GLOBAL FUNDAMENTAL CREDIT
COMMON INSTITUTIONAL APPLICATIONS
6
COMMON INSTITUTIONAL APPLICATIONS Fixed income ETFs are increasingly being viewed as financial market instruments or capital markets tools and are being used by investors alongside other instruments such as cash bonds and index derivatives. Fixed income ETFs are a valuable tool for navigating stressed markets, providing additional liquidity and real-time price information.
[58] THE GUIDE TO FIXED INCOME E TFs
CASH AND LIQUIDITY MANAGEMENT NICHE MARKET ACCESS
TRANSITION MANAGEMENT
TACTICAL ASSET ALLOCATION
PORTFOLIO CONSTRUCTION TRADING TOOLS
THE GUIDE TO FIXED INCOME E TFs [59]
COMMON INSTITUTIONAL APPLICATIONS
6
CASH AND LIQUIDITY MANAGEMENT ETFs can be added to portfolios to provide an additional liquidity point, acting as a buffer to help manage inflows and outflows as well as serving a role in managing portfolio beta. Subscriptions and redemptions can be disruptive to an investor’s portfolio performance: either because the need to meet redemptions may require assets to be liquidated during difficult market conditions or because subscriptions and challenges sourcing bonds may result in excess cash positions. Larger ETFs with more liquid secondary markets may have substantially narrower bid/offer spreads than those of the underlying assets. Therefore using ETFs as vehicles to manage cash flows and/or adjust portfolio beta tactically could save the portfolio significant execution costs.
[60] THE GUIDE TO FIXED INCOME E TFs
EXAMPLE: PORTFOLIO STRUCTURE OPTIONS WHEN PORTFOLIO HAS A LARGE REDEMPTION OPTION Cash
Use 100% cash to pay for the redemption. This could reduce flexibility within the portfolio going forward.
1
Derivative overlays
OPTION BETA EXPOSURE
Cash bonds
2
Sell cash bonds to pay for the redemption. This could prove expensive if the assets are being sold in a difficult market.
OPTION ETFs
3
Sell your ETF in the market, using the cash to pay for the redemption. The ETF acts as a liquidity sleeve, giving the fund additional flexibility to meet a redemption without having to significantly reduce cash or single bonds in the fund.
For illustrative purposes only.
T HE G U ID E T O F I X ED IN C O ME E T F s [61]
COMMON INSTITUTIONAL APPLICATIONS
6
CASE STUDY: MINIMISE CASH DRAG WITH FIXED INCOME ETFs A high yield asset manager generated a 5-year cumulative return that slightly underperformed the strategy benchmark. After analysing the portfolio’s performance, the manager found the 5% cash allocation had resulted in a cumulative 1.4% drag on performance. The analysis showed that the manager could have significantly reduced the impact of cash drag by allocating 3% to a high yield corporate bond ETF and only 2% to cash. The solution would have reduced cash drag during the prior 5-year period to 0.7%, inclusive of transaction costs. This would have made the difference between outperforming and underperforming the strategy benchmark. Given the manager’s need to meet cash flows, liquidity was a key consideration when selecting an ETF. This enabled the high yield corporate bond ETF to act as a liquidity tool in a part of the market that can suffer from low trading volumes. By holding the high yield corporate bond ETF, the manager was able to lower the impact of cash drag while maintaining flexibility for cash flow needs.
[62] THE GUIDE TO FIXED INCOME E TFs
REDUCE THE EFFECT OF CASH DRAG WITH AN ETF 5-YEAR CUMULATIVE CASH DRAG
% 0.5 0.0 -0.71%
-0.5 -1.0 -1.5 -2.0
-1.42%
-2.5 -3.0 -3.5 Dec 10
Dec 11
Dec 12
Dec 13
Portfolio with 5% cash
Dec 14
Dec 15
Portfolio with 2% cash and 3% ETF
Sources: Morningstar, BlackRock, as of 31 December 2015. For illustrative purposes only. Not indicative of any actual portfolio or asset allocation model. ‘Portfolio with 5% Cash’ assumes allocation of 95% to BAML High Yield Master II Index and 5% invested in a money market fund, rebalanced monthly. No additional transaction costs are assumed. ‘Portfolio with 2% Cash & 3% ETF’ assumes allocation of 95% to BAML High Yield Master II Index, 2% invested in a money market fund and 3% invested in Markit iBoxx USD Liquid High Yield Index, rebalanced monthly and assumes 2 bps of round-trip transaction costs for the Markit iBoxx USD Liquid High Yield Index investment per month. Past performance does not guarantee future results. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. Case studies are for illustrative purposes only; they are not meant as a guarantee of any future results or experience. Index returns are for illustrative purposes only and do not represent actual iShares Fund performance. Index performance returns do not reflect any management fees, transaction costs, or expenses. Indices are unmanaged and one cannot invest directly in an index.
THE GUIDE TO FIXED INCOME E TFs [63]
COMMON INSTITUTIONAL APPLICATIONS
6
NICHE MARKET ACCESS Given the backdrop of historically low interest rates, investors are increasingly considering less familiar sectors of fixed income such as emerging market debt as they search for yield. While investors need to be cognisant of the risks, adding additional exposure has the potential to increase yield without assuming higher levels of duration. Additionally, the inclusion of uncorrelated assets may reduce volatility and increase return potential for the overall portfolio. However, investing in less familiar asset classes is rarely straightforward. Investors may face difficulties sourcing bonds, such as: `` Establishing local custodial or brokerage relationships `` Understanding and meeting requirements for owning local currency bonds `` Navigating the restrictive tax policies of many countries Because of these challenges, investors are increasingly turning to ETFs to gain exposure to asset classes such as emerging market bonds. Fixed income ETFs allow investors to access difficult-to-reach areas of the global bond market through diversified and liquid vehicles.
[6 4] THE GUIDE TO FIXED INCOME E TFs
EMERGING MARKETS `` Potentially higher yields relative to developed markets `` Low correlation to developed market bonds `` Higher exposure to credit risk `` Local currency exposure may increase returns, but adds volatility `` Increased price appreciation potential due to improving credit quality of emerging market countries
THE GUIDE TO FIXED INCOME E TFs [65]
COMMON INSTITUTIONAL APPLICATIONS
6
TACTICAL ASSET ALLOCATION ETFs are frequently used as tactical asset allocation tools enabling investors to take advantage of market sentiment. Key benefits include the ability to gain market exposure in a timely, cost effective and efficient manner, particularly in parts of the fixed income market that can be more difficult to access. The use of ETFs as beta access vehicles serves a valuable purpose where investors lack in-house expertise or research capabilities in a given asset class or region. ETFs provide the ability to express a broad based market beta view without taking idiosyncratic, issuer specific views.
SPREAD TO BENCHMARK (BPS)
In this illustration a Euro investment grade manager takes a tactical view on European high yield corporate bonds implemented through the iShares € High Yield Corp Bond UCITS ETF EUR (Dist) (IHYG). iShares € High Yield Corp Bond UCITS ETF EUR (Dist) (IHYG)
Euro investment grade bonds
Euro investment grade bonds
iSHARES € HIGH YIELD CORP BOND UCITS ETF EUR (DIST) (IHYG) SPREAD TO BENCHMARK 550
SPREAD (BPS)
500 450 400 350 300 Dec 14
Mar 15
Source: Bloomberg. For illustrative purposes only. [66] THE GUIDE TO FIXED INCOME E TFs
Jun 15
Sep 15
Dec 15
TRADING TOOLS Fixed income ETFs are increasingly being used as trading tools alongside cash bonds and index derivatives. As ETF liquidity has deepened and bond market liquidity has declined, investors are adding ETFs as an alternate source of liquidity or using ETFs as a means of expressing a view. Portfolio managers are finding uses for ETFs in their portfolios to aid alpha generation: `` Access liquid beta during periods of low liquidity `` Generate carry by lending the units of the ETF `` As a cash bond alternative to index derivatives `` Express relative value views `` Hedge cash bond portfolios
THE GUIDE TO FIXED INCOME E TFs [67 ]
COMMON INSTITUTIONAL APPLICATIONS
6
PORTFOLIO CONSTRUCTION TOOLS Constructing a new diversified portfolio or putting to work a significant inflow of cash into an existing portfolio efficiently may be difficult. ETFs may be used as an efficient tool to access the market quickly and may be used to gain efficient and diversified fixed income beta exposure in the ramp-up stage of a portfolio. Smaller portfolios, where achieving diversified exposure to various fixed income asset classes may not be practical, may also benefit from ETFs as an instrument to achieve target allocations. Ultimately, once the portfolio reaches a certain scale an investor may seek to redeem in-kind, thereby saving transaction costs as they move from the ETF to holding the underlying cash bonds.
[68] THE GUIDE TO FIXED INCOME E TFs
EXAMPLE: GLOBAL AGGREGATE BOND PORTFOLIO Mortgage allocation through ETF
GLOBAL AGGREGATE BOND PORTFOLIO
Individual bonds For illustrative purposes only.
THE GUIDE TO FIXED INCOME E TFs [69]
COMMON INSTITUTIONAL APPLICATIONS
6
CASE STUDY: PORTFOLIO CONSTRUCTION AND REDEMPTION IN-KIND An institutional investor purchased €25 million of a Euro Corporate Bond ETF with the end goal of building up positions for a separate account. For a 5-week period, the investor purchased shares of the ETF on the secondary market. Subsequently, the investor then redeemed shares of the fund and took delivery of a basket of 40 bonds for the separate account. By utilising the secondary market liquidity of the ETF, the investor was able to save on transaction costs relative to buying the redemption basket of bonds directly.
USING ETFs AS AN INITIAL PORTFOLIO BETA VEHICLE
INVESTOR’S CASH
ETF PURCHASED THROUGH A BROKER
1
[70] THE GUIDE TO FIXED INCOME E TFs
EURO CORPORATE BOND ETF HOLDING MORE THAN 1000 BONDS
PHASE 1: GAINING DIVERSIFIED MARKET BETA EXPOSURE EFFICIENTLY
COMMON INSTITUTIONAL APPLICATIONS
6
IN-KIND REDEMPTION THROUGH A BROKER
2
INVESTOR OWNS 40 BONDS
PHASE 2: TRANSITION TO BONDS
T HE G U ID E T O F I X ED IN C O ME E T F s [ 71]
TRANSITION MANAGEMENT As part of a transition, ETFs may be used by an investor as a cost effective way of gaining transparent and passive interim beta exposure. This enables the investor to maintain market exposure while conducting manager due diligence or undertaking a search process. The investor benefits from the secondary market liquidity of the ETF holdings in the interim. Ultimately they may seek to redeem in-kind, thereby saving transaction costs as they move from the ETF to holding the underlying cash bonds.
MAINTAIN LIQUID BETA EXPOSURE WHILE SEARCHING FOR NEW MANAGERS OR REBALANCING LEGACY
TRANSITION PERIOD
ACTIVE EMERGING MARKET DEBT MANAGER
iSHARES J.P. MORGAN $ EM BOND UCITS ETF USD (Dist) (IEMB)
Existing active mandate due to be terminated
Due diligence process to find a new manager interim solution: ETF used to achieve beta performance
For illustrative purposes only.
[ 72] THE GUIDE TO FIXED INCOME E TFs
COMMON INSTITUTIONAL APPLICATIONS
6
NEW NEW EMERGING MARKET DEBT MANAGER New active mandate is set up
THE GUIDE TO FIXED INCOME E TFs [ 73]
CASE STUDY: CUSTOMISED SOLUTIONS ETFs could provide solutions for legacy and run-off portfolios. BlackRock can screen an investor’s portfolio to determine the potential to use existing holdings to create units in ETFs. This provides the investor with a more manageable portfolio with far fewer line items, a clearer risk profile and a potentially better match for a target asset allocation.
PORTFOLIO SCREENING
Additionally, should the investor wish to manage out of the legacy portfolio, the secondary market liquidity of the ETF holdings may provide better execution versus disposing of the underlying portfolio directly.
LEGACY PORTFOLIO OF BONDS
For illustrative purposes only.
1. Excluded securities: Portfolio screening excludes securities that are not in the indices that the iShares ETF tracks and those that do not fit into the fund profile.
[ 74 ] T H E G U I D E T O F I X E D I N C O M E E T F s
COMMON INSTITUTIONAL APPLICATIONS
6
HOLD ETF FOR BETTER BENCHMARK TRACKING SELL ETF IN SECONDARY MARKET
THE GUIDE TO FIXED INCOME E TFs [75]
“
As the European ETF landscape matures, the usage of ETFs as capital markets instruments is evolving. ETFs are being viewed by institutional investors as simple to implement tools to express their views in increasingly sophisticated ways.
“
Rachel Lord BLACKROCK’S HEAD OF EMEA iSHARES
FIXED INCOME ETF MARKET STRUCTURE DEVELOPMENTS
7
FIXED INCOME ETF UNIT LENDING Fixed income ETFs typically lend a portion of the underlying bonds within the fund according to the fund’s investment guidelines to generate additional return for the fund. However investors should also be aware that it is possible to lend the ETF units themselves in order to generate further incremental return for the unit holder. Whilst still at an early stage of development, compared to US ETFs (and underlying equity markets), borrowing and lending of ETF units in Europe is becoming more common. Securities lending is a well-established practice where beneficial owners make short-term loans of securities (typically through a lending agent, their custodian bank), to unlock additional value in portfolios and collect higher returns than would otherwise be received.
LENDER
BENEFICIAL OWNERS
MUTUAL FUNDS, ETFs, PENSION FUNDS AND INSURANCE
BORROWER
INTERMEDIARIES
LENDING AGENT AND CUSTODIANS
COMPANIES
For illustrative purposes only.
[ 78] THE GUIDE TO FIXED INCOME E TFs
INVESTMENT BANKS AND BROKER-DEALERS
END USERS
HEDGE FUNDS, BROKER-DEALERS AND INVESTMENT BANKS
HOW EASY IS IT TO SET UP? `` Once the decision has been taken to lend, set up is straight forward `` All major custodians have a platform to lend securities and make the client experience as seamless as possible All operational aspects of securities lending transactions are typically managed by the lending agent. Once established in a lending programme, the process is very low touch for beneficial owners. CAN I SELL MY ASSETS IF OUT ON LOAN? Yes – securities may be sold at any time. A borrower has a legal and contractual obligation to return securities in good time for settlement. WHAT IS MY NEXT STEP? `` Speak to your custodian `` iShares Capital Markets team are more than willing to help facilitate discussions regarding the lending of ETF units
THE GUIDE TO FIXED INCOME E TFs [ 79]
FIXED INCOME ETF MARKET STRUCTURE DEVELOPMENTS
7
ETFs AS ACCEPTABLE COLLATERAL Clients who utilise unfunded instruments within their investment portfolios are typically required to post collateral on an ongoing basis to futures clearing venues for futures contracts and investment banks for OTC swap transactions. ETFs’ role as collateral in such transactions is currently nascent, however, important market standards are now in place to assist clients in more efficiently using their ETF holdings in such pledging transactions. The historical challenge for ETFs is the broad classification of the product and the inability to systematically assess the risk characterisation of the asset. This made ETFs particularly onerous for risk departments to evaluate when updating counterparty collateral schedules and to use by collateral managers. In response to this challenge, Markit is launching two initial ETF Collateral Classification Filters in 2015, one equity and one government bond.
[80] THE GUIDE TO FIXED INCOME E TFs
MARKIT GOVERNMENT BOND ETF COLLATERAL FILTER ETF
CLASSIFICATION TYPE
ETF ETF
Investment approach
ETF
ETF
Geographic exposure Asset class
ETF
Germany, France, UK, US ETF
ETF
ETF
Fixed income
ETF
ETF
ETF ETF
Investment focus ETP leverage ratio Holding type Management structure Assets under management (USD) Tracking error
ETF
ETF ETF
ETF
ETF
Government Short term, intermediate term 1.0X
ETF
ETF
CRITERIA
ETF ETF
ETF ETF
ETF
ETF ETF
ETF
ETF
ETF
Physical Replicated and optimised >$100mn
