Fixed Income ETFs and the Corporate Bond Liquidity Challenge Greg Walker, CFA Managing Director, Head of ishares Business Development

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Fixed Income ETFs and the Corporate Bond Liquidity Challenge

Greg Walker, CFA Managing Director,

Head of iShares Business Development

For professional clients / qualified investors only

March 3, 2015

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Agenda

1. Bond Buyers Challenge

2. Application of Fixed Income ETFs

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For accredited investors in Canada only- Proprietary and Confidential

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Bond Buyers Challenges

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Primary dealers are holding less inventory on their balance sheets due to the impact of regulatory changes from Volcker Rule and Basel III.

 Liquidity has been reduced and bid-ask spreads have widened – IG bid-ask spreads have widened 57% from 2007

 New issues are 3.4x oversubscribed and only allocated to large fixed income managers

 Finding actionable bids and offers in volatile markets can be difficult, especially when less than one third of large corporate bonds trade daily

4 Falling Bond Inventory at Broker Dealers

2%

9%

23%

38%

29%

0%

5%

10%

15%

20%

25%

30%

35%

40%

0-5 6-10 11-15 16-19 20+

Percent of Index Constituents

Average # days bonds in the Markit iBoxx $ Liquid Investment Grade Index traded each month

Least liquid Most liquid

Most Large Corporate Bonds Do Not Trade Daily

Source: Federal Reserve Bank of New York, Barclays, as of 12/31/2014 . BlackRock, Markit iBoxx, Trace. Data from 1/1/2013–12/31/2013 for the Markit iBoxx $ Liquid Investment Grade Index (“investment grade”). There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.

Recent Trends Illustrate Less Liquidity in the US Bond Market

0 500 1000 1500 2000 2500 3000 3500 4000 4500

- 50 100 150 200 250

Corp (Before 4/1/2013) RMBS

CMBS Commerical Paper

High Yield Inv Grade

Barclays Corp Index Market Value

For accredited investors in Canada only- Proprietary and Confidential

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Fixed income ETFs

Exchange listed like a stock

Diversified like a portfolio of bonds

Bond ETF features Primary uses

Rather than trading in the over-the-counter (OTC) bond market, investors can access these exposures on an exchange which can lower the cost of trading and improve price transparency.

 Fixed Income ETFs are generally fully funded, unlevered vehicles that hold physical bonds

 Institutional investors primarily use fixed income ETFs as core long-term investment holdings, tools for targeting precision exposures, and as financial instruments that serve as substitutes or complements to derivative-based beta vehicles

Fixed Income ETFs Offer an Alternative to Better Maintain Expected Yield

Core investments

Precision exposures

Substitute or complement to derivatives

For accredited investors in Canada only- Proprietary and Confidential

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Fixed Income Liquidity During Stressed Markets

For illustrative purposes only.

Corporate Bond and ETF Volume (Monthly)

$0

$5

$10

$15

$20

$25

1/08 Underlying Bond Average Daily Volume ($ Billions)

$0

$20

$40

$60

$80

$100

$120

$140

$160

$180

Average Daily Volume- ($ Millions)

Corporate Bonds ADV Investment Grade Corporate Bond ETF ADV

2/08 3/08 4/08 5/08 6/08 7/08 8/08 9/08 10/08 11/08 12/08 1/09 2/09 3/09 4/09 5/09 6/09 7/09

During late 2008, when the credit markets became dislocated and illiquid, Investment Grade Corporate Bond ETFs rose significantly as investors began using ETFs for corporate bond exposure

For accredited investors in Canada only- Proprietary and Confidential

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Source: BlackRock and Bloomberg as of 6/30/14.

Assets have climbed 380% since 2008 as investor adoption has increased and existing users have broadened their usage

Growth of Fixed Income ETFs

US Fixed Income ETF AUM is Over $270B

0 50 100 150 200 250 300

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 YTD 2014

Total AUM ($B)

Mortgage

Leveraged/Inverse Aggregate

High Yield IG Credit Bank Loans Inflation-Linked Government Govt/Credit Municipals

Fixed income ETF usage has grown significantly, solving many challenges of trading in the OTC market

Growth in fund size, breadth of bond market exposures, and liquidity have continued to drive increased adoption of ETFs

A wide cross section of investors, such as endowments and foundations, asset managers, insurance companies, and pension funds are now pioneering new investment approaches using ETFs

For accredited investors in Canada only- Proprietary and Confidential

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The Majority of ETF Trading Occurs on the Exchange

Secondary to Primary Market Ratio

Sources: BlackRock and Bloomberg, as of September 2014.

For illustrative purposes only. The performance quoted represents past performance and does not guarantee future results.

0 2 4 6 8 10 12 14 16

1/29/2014 2/28/2014 3/31/2014 4/30/2014 5/31/2014 6/30/2014 7/31/2014 8/31/2014

1-5 Year Laddered Corporate Bond Index ETF

Canadian Short Term Bond Index ETF

For accredited investors in Canada only- Proprietary and Confidential

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20+ Year Treasury Bond ETF iBoxx $ High Yield Corporate Bond ETF

iBoxx $ Investment Grade Corporate Bond ETF

1-3 Year Treasury Bond

ETF TIPS Bond ETF Core Total US Bond

Market ETF

JP Morgan USD Emerging Markets Bond ETF

ADV($M)** 854 240 102 54 52 96 83

AUM ($M) 3,731 13,746 17,816 7,931 13,192 17,643 5,191

*Market Bid/Offer spread refers to the underlying securities of the respective index

**20-day average daily volume, as of 6/30/2014.

For illustrative purposes only. Source: BlackRock, Bloomberg, Barclays, NYSE Arca, as of 6/30/2014. Assets in USD

ETFs generally offer price improvement, making the ETF less expensive to trade than the underlying securities of the respective index

Fixed Income ETF Transaction Cost Savings

1 5 1 1 1 2 1 2

40

25

2

15 15

78

0 10 20 30 40 50 60 70 80 90

Bid/Offer Spread (bps)

iShares Bid/Offer Basket Bid/Offer* (est.) ETF Bid/Offer

For accredited investors in Canada only- Proprietary and Confidential

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Cost Effectiveness: Add another Layer of Cost Efficiency to Your Bond Trading

Canadian HYBrid Corporate Bond Index ETF

Canadian Corporate Bond Index ETF

1-5 Year Laddered Corporate Bond Index ETF

Core Canadian Short Term Corporate Maple Bond Index

ETF

Canadian Universe Bond Index ETF

Canadian Short Term Bond Index ETF

Canadian Government Bond Index ETF

Average Daily Volume (30

Day) ($M) 0.7 6.7 6.6 1.2 3.9 6.5 0.8

Assets Under Management

($M) 385 1,474 2,296 168 1,562 2,342 234

58

43

23

20

13

9 7

14

6 6

12

4 4

9

- 10 20 30 40 50 60 70

Basket Spread (bps) ETF Spread (bps)

ETFs can offer price improvement making the ETF less expensive to trade than the underlying securities of the respective index

Source: Bloomberg, BlackRock as at 18th September 2014. Assets in CAD

This material may not be distributed beyond its intended audience. - Proprietary and Confidential 10

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Application of Fixed Income ETFs

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1) Core FI Allocation

A Canadian based Discretionary PM needed to “park” a cash balance of around $40m for 4 months before allocating into equity ETF exposures .

 The PM selected 4 floating rates bonds they were comfortable as a temporary fixed income exposure.

 Then asked their bond desk to price the bonds in an equal weight.

 The client was unhappy with the bid offer cost quoted by the bond desk, especially given the holding time of only 6 months.

 The client was able to trade the Floating Rate Index ETF with very similar exposure to the floating rate notes the client had selected.

 The client traded in and importantly out of the Floating Rate Index ETF paying in total a 2c bid offer spread (10bps

).

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Solution

Client Challenge

Source Bloomberg as at 30th September 2014. Case study shown for illustrative purposes only. This is not meant as a guarantee of any future result or experience. This information should not be relied upon as research, investment advice or a recommendation regarding the iShares Funds or any security in particular. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.

This material may not be distributed beyond its intended audience. - Proprietary and Confidential

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2) Improve the Portfolio’s Liquidity Profile – “Liquidity Sleeve”

A US insurance company with $3bn of credit bonds was looking to enhance the liquidity of their portfolio without sacrificing yield or credit quality.

 The solution reduced turnover by moving the maximum number of bonds into $738mm of the iBoxx $ Investment Grade Corporate Bond ETF

 The iBoxx $ Investment Grade Corporate Bond ETF increased the liquidity profile of the portfolio as the fund trades over $420mm a day on exchange

 The number of line items was reduced by 75% from approximately 400 to 100

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Solution

Client Challenge

1,000 1,500 2,000 2,500 3,000 3,500 4,000

- 50 100 150 200 250

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Primary Dealer Corp. Positions (>1 Yr Maturity) (LHS) Market Value of the IG Corp Index (RHS)

Falling Bond Inventory at Broker Dealers

 Cash bond liquidity has been impaired due to regulatory

restrictions impacting broker dealer inventories

 The client’s risk department had concerns about quickly liquidating their position in case of a market disruption

Source: Bloomberg as of 6/28/2013.

Case study shown for illustrative purposes only. This is not meant as a guarantee of any future result or experience. This information should not be relied upon as research, investment advice or a recommendation regarding the iShares Funds or any security in particular. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.

This material may not be distributed beyond its intended audience. - Proprietary and Confidential

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3) Fixed Income Transition Trades Case Study - October 2014

An Asset Manager was looking to increase the overall liquidity, scalability and operational efficiency of their $23m fixed income portfolio allocation.

 The client expressed that the current Canadian cash bond market lacked the necessary liquidity, inventory and transparency needed to manage their portfolio in their desired way.

 The client selected 2 fixed income ETFs as a way to access their desired fixed income exposure:

Canadian Universe Bond Index ETF $20m Canadian Short Term Bond Index ETF $3m

 The client was looking for an efficient and fast way to trade out of their existing 29 line items across both a rates and credit portfolio and into the Canadian Universe Bond Index ETF and the Canadian Short Term Bond Index ETF

 The results determined that 28 of the 29 line items could be accepted as a creation trade into the Canadian Universe Bond Index ETF and the Canadian Corporate Bond Index ETF.

 The client was able to create the Canadian Universe Bond Index ETF and the Canadian Short Term Bond Index ETF via the in kind creation process, where the bonds were exchanged for both priced using the index price, in this case FTME TMX mid.

 Post trade analysis, utilizing current bids and offers for the same bonds at the time of the trade shows that the client avoided approximately 11 bps or $28,000 in spread costs by delivering in-kind (via an AD) the bonds into ETFs rather than selling them in the cash bond market.

Case study shown for illustrative purposes only. This is not meant as a guarantee of any future result or experience. This information should not be relied upon as research, investment advice or a recommendation regarding the iShares Funds or any security in particular.

Client Challenge

Solution

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Disclaimer Information

All information about U.S.-based iShares funds is intended for institutional investors in Canada only. Institutional investors must satisfy the eligibility criteria set forth in the Terms & Conditions. If you do not meet this eligibility criteria, do not access or use the institutional investor section of the BlackRock.com/ca website or the

information concerning U.S.-based iShares funds provided herein. The U.S.-based iShares funds have not been nor will they be qualified for sale to the public under applicable Canadian securities laws and, accordingly, any purchase or sale of the U.S.-based iShares funds in Canada that occurs as part of a distribution, and any subsequent resale, must be made on a basis which is exempt from or not subject to the prospectus requirements of Canadian securities laws. You are advised to seek Canadian legal advice prior to any purchase or resale of U.S.-based iShares funds.

iShares® ETFs are managed by BlackRock Asset Management Canada Limited or its affiliates. Commissions, trailing commissions, management fees and expenses all may be associated with investing in iShares ETFs. Please read the relevant prospectus before investing. The funds are not guaranteed, their values change

frequently and past performance may not be repeated. Tax, investment and all other decisions should be made, as appropriate, only with guidance from a qualified professional.

© 2015 BlackRock Asset Management Canada Limited. All rights reserved. iSHARES, ALADDIN and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. Used with permission.

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