iShares predicts higher demand for fixed income ETFs

The dislocation in the fixed income market triggered by the eurozone sovereign debt crisis and investors’ desire for more granular exposure are significantly driving the growth of bond ETFs, explains Alex Claringbull, senior fixed income portfolio manager for iShares Emea.

Fixed income ETFs were very underrepresented until the financial crisis in 2007-2008. Then, investors’ need to de-risk their portfolios away from commodities and equities, combined with the desire for simple and transparent products drove the first growth phase of fixed income ETFs, he says. “We are now in the second growth phase and that’s really being caused by this dislocation in the fixed income market and people wanting more granular choice.

“People used to think of all of Europe as a one homogenous pot, but over the last two years it has become clear that these countries are all very different from each other.”

To meet investors’ demand, iShares recently launched eight funds offering targeted exposure to the sovereign debt of eight eurozone countries. “We want to provide the building blocks and let investors package them together. We wouldn’t pick the winners and losers,” says Mr Claringbull.

Italian or Spanish government bond ETFs will attract home country-biased domestic investors as well as those willing to take more risk for that yield or extra coupon flows that come with Italian or Spanish government bonds, relative to German, Austrian or Dutch government bonds, he states.

In general, fixed income is no longer the same asset class it once was. Investors are increasingly diversifying their holdings by issuer and sector, credit quality, region and currency in an effort to secure new sources of income and to spread risk, explains Mr Claringbull. This will benefit emerging markets ETFs in particular.

“Emerging markets are structurally underrepresented in fixed income ETFs, that’s the area that is poised to grow.” Emerging market fixed income ETFs provide diversification benefits from a currency perspective and access to the emerging market growth story. “There is more risk in those assets but if you are a longer term investor, you are less worried about the daily price volatility and are more interested in getting the yearly coupon.”

Emerging markets today represent only about 5 per cent of the total AUM in fixed income ETFs, according to BlackRock.

WINDOW TO THE MARKET

One of the key questions around ETFs, in particular in fixed income, given some bad results in the industry, is around their ability to track the indices, explains Mr Claringbull.

“An ETF is just a window to the underlying market. The most liquid market in the world is US Treasuries and our iShare on US Treasuries is very liquid, with 1 or 2 basis points bid offer spread. But going into emerging markets, the bid offer spread can be 75 to 100 basis points in fixed income,” he says.

If this is the type of liquidity that interests a client buying and selling the ETF, for a portfolio manager it is about making sure that the fund is positioned correctly and is able to track the index. “I deal with liquidity because I have to buy and sell securities as they come in and out of the index I am tracking.”

In line with the company’s philosophy, all iShares’ fixed income ETFs are physically replicated and do not make use of derivatives. When they are sampled, the sampling is very conservative, states Mr Claringbull.

When securities are bought in the secondary market, it is important to be a significant investor such as BlackRock to get a better pricing and control transactional costs, he says. “We can access liquidity where other people can struggle.”

In the emerging market fixed income space there is no demand yet for single country products. “We are in the first phase of development in local currency and also in dollar, and we offer regional blocks such as Asia or global. We need to launch funds with a reasonable amount of seed capital and to get that seed capital we need to prove to our partners there is enough client demand.”

Fund size is important to contain the tracking error. “If the benchmark is made of 500 bonds, unless you have a good pool of money, how many can you buy? We have to have confidence that we can run the product effectively from day one.”

Future trends

iShares expects the global fixed income ETF market will exceed $2tn (€1.6tn) in assets over the next decade, compared with $302bn today. The US fixed income ETF market will likely grow to around $1.4tn in assets, with Emea and Asia taking the remaining $600bn in assets.

During 2012’s first half, fixed income exchange traded products (ETPs) attracted $40.8bn in net new assets, with flows into the products accounting for 40 percent of all global ETP inflows, according to BlackRock. “Even after a decade of continuous growth, fixed income ETFs are still just scratching the surface of their potential,” says Jennifer Grancio, head of iShares global business development at BlackRock.

Alex Claringbull, iShares