How volatility and performance in 2020 accelerated institutional adoption of fixed income ETFs

Brett Olson, EMEA Head of iShares Fixed Income ETFs at BlackRock

In the extreme financial asset volatility in the first half of 2020, the largest and most heavily traded fixed income ETFs performed a critical role and demonstrated that they are integral to efficient bond markets.

In their biggest test to date, the most heavily traded fixed income ETFs provided deep liquidity, continuous price transparency and lower transaction costs than were available in individual bonds. The ability to buy and sell portfolios of bonds held in ETFs helped investors navigate extreme price dislocations and sidestep a legacy marketplace that remains fragmented and comparatively difficult to access even for institutional investors. In many cases, institutional investors chose to use fixed-income ETFs rather than fixed income derivatives. As a result, asset owners – including pension funds and insurance companies and asset managers – ramped up adoption. In recent months, these large investors have increased their use of fixed income ETFs at scale, regularly with positions sized in the hundreds of millions of dollars, as substitutes for individual bonds and fixed income instruments. Globally, BlackRock counted over 60 asset owners and asset managers that were first-time buyers of iShares fixed-income ETFs in the first half of 2020. We estimate this group collectively added about $10 billion in assets.

There is significant room for fixed income ETF asset growth as adoption by institutional investors accelerates. Global fixed-income ETF assets accounted for US$1.3 trillion at the end of June 2020 after growing 30% in just one year; still, ETFs represent only about 1% of the US$100 trillion global fixed income securities market. Bolstered by recent adoption patterns, BlackRock believes that institutional investors will help expand global fixed income ETF assets to US$2 trillion by 2024. Our July 2020 report, Turning Point, provides the facts around how fixed income ETFs performed during the severe market conditions of early 2020. It also gives examples of how some of the world’s leading active asset managers, insurance companies and pension funds are using fixed-income ETFs to improve outcomes for their clients.

Fixed-income ETFs shone in 2020’s market volatility
The onset of the pandemic triggered unusual disruptions across fixed income markets and led to an uptick in activity for fixed income ETFs which iShares pioneered in 2002. While the transparency, liquidity and efficiency of on-exchange trading had already proven valuable to fixed income investors during multiple periods of market stress over the past decade, certain market participants continued to theorise about what might happen should fixed income ETFs be tested by a monumental market shock. They raised questions about whether ETFs would be able to withstand the pressure of continuous selling, and whether they might exacerbate price declines in the underlying markets. The results were clear: fixed income ETFs not only held up under stress, but they also became important tools for market participants by offering immediate trading at transparent prices, a combination that was often not available with individual bonds. Institutions turned to the most liquid fixed income ETFs as sources of real-time price discovery and cost-efficient execution when transparent quotations and liquidity had sharply deteriorated in individual bonds.

When volatility struck, fixed income ETF trading surged
Investors have always tended to use fixed income ETFs even more during times of uncertainty because they are efficient and effective tools for rebalancing holdings, hedging portfolios and managing risk. From late February through late March 2020, iShares UCITS fixed income ETF trading surged to US$17.5 billion on average, more than twice the 2019 weekly average of US$7.8 billion. Trading volume in UCITS high yield fixed income ETFs averaged as much as US$620 million per day in March 2020 with US$13.4 billion traded in total over the month. For comparison, high yield UCITS ETFs averaged US$290 million per day in 2019.4 The trend was similar in UCITS investment grade corporate ETFs where trading in March 2020 averaged US$1.67 billion per day, giving a monthly total of US$36.3 billion compared to US$740 million daily average in 2019. In both high yield and investment grade, as markets became more volatile, investors turned to fixed income ETFs almost entirely driven by elevated costs to trade against the backdrop of exceptionally high intra-day volatility in rates and credit markets, coupled with the lack of liquidity in underlying cash bond markets.

Amid increased trading, fixed income ETFs were indicators of real-time, actionable prices
Many fixed income ETFs traded hundreds of millions of dollars per day during the peak of 2020’s early-year market volatility. This was far more often than even the most heavily traded corporate bonds.
On 12 March, one of the worst days for equity markets in modern history and a day during which credit markets sold off sharply, a large USD-denominated investment grade corporate bond UCITS ETF traded almost 1,000 times on exchange compared with just 37 times on average for its largest five bond holdings. Throughout March, more than half of this ETF’s bonds traded between zero and five times per day, on average, while the ETF traded more frequently than the bonds in the underlying portfolio. High trading volumes support the notion that fixed income ETFs provided actionable prices for investors at a time when the underlying bond market was challenged. The on-exchange market prices for fixed income ETFs reflected both absolute and relative value and helped enable investors to understand rapidly changing market conditions. Because they offer real-time pricing and trade often, fixed income ETFs are now central to valuation, portfolio construction and risk management for institutional investors. Fixed income ETFs have emerged as benchmark references for returns, volatility and market sentiment.

Conclusion
An eruption of market volatility in early 2020 touched nearly every corner of the fixed income markets. For institutions, the episode highlighted that the over-the-counter bond market remains relatively opaque and fragmented, despite improvements made in recent years. Recent trends underscore BlackRock’s view that institutional investors will propel future fixed income ETF growth, which remains just a fraction of total global fixed income assets. We reaffirm our projection from a year ago that global fixed income ETF assets will double to US$2 trillion, by 2024, aided by the important role that fixed income ETFs are playing in the modernisation of fixed income market structure, the evolution of portfolio construction and constant product innovation. Indeed, the pace of growth could be faster than we expect. In the year since we made this projection when fixed income ETF assets crossed US$1 trillion in assets, assets grew by more than 30%, nearly all of which was organic growth. As more asset managers and asset owners embrace fixed income ETFs as an efficient, transparent and convenient way to access the bond market especially in times of volatility the prospects for growth will only look brighter.