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By Jason Voss, CFA

At the recent Fixed-Income Management 2012 conference in San Francisco, BlackRock’s Matthew Tucker, CFA, managing director and head of the firm’s iShares Fixed Income Strategy team, delivered a valuable primer on fixed-income exchange-traded funds (ETFs). Because of the sheer variety of such instruments available in the marketplace today, nearly any investor looking to buy a bond should at least consider the ETF alternative. And based on the numerous questions from the audience of seasoned investment professionals, it’s not just those who are new to finance that could benefit from a deeper understanding of how these products can be employed to achieve a variety of investment goals.

ETFs are managed portfolios of securities that are organized similarly to mutual funds, with one key difference: ETFs trade on a stock exchange and thus permit intraday buying and selling. In addition, transactions costs are extraordinarily low relative to outright purchases and sales of the underlying securities. For instance, the Barra Fixed-Income Aggregate ETF has a “round trip” (buy and sell) transaction cost of just 0.02%, or two basis points (bps) in investment parlance, compared to around 13 bps to purchase the portfolio as a separate basket of securities.

The first ETFs were equity based, but the universe of fixed-income ETFs now includes more than 200 products, with about $225 billion in assets under management, Tucker noted. Trading volumes have soared to $100 billion per month, and since 2008, fixed-income ETF trading has experienced a compound annual growth rate of more than 45%. This liquidity allows fixed-income investors to use ETFs for price discovery. Their flexibility also means that investors can use them for tactical trading, arbitrage, and index exposure.

Price Discovery

The fixed-income community used to complain that ETFs did not accurately price underlying portfolios of bonds. But the instruments are now acknowledged by both researchers and practitioners as the most consistently accurate source of pricing in fixed-income markets. Studies have routinely demonstrated that changes in the pricing of fixed-income ETFs presage changes in the prices of underlying bonds, Tucker said.

This has been a big step forward for transparency. In years past, bond-trading desks took advantage of opaque fixed-income markets by quoting different bond prices to clients based on the quality of their relationship to the firm. (Keep in mind that only 28% of investment-grade bonds and less than 10% of high-yield bonds trade in any given day.) But because fixed-income ETFs trade daily, they have been a game-changer with regard to price discovery.

Tactical Trading

Fixed-income ETFs allow investors to position themselves relative to their outlook for overall credit quality in the market, changes in duration or convexity, and shifts in the yield curve. Here again liquidity is key, enabling market participants to buy or even short ETFs based on their investment views during market hours. So, for example, if it is the view of BlackRock’s Fixed-Income CIO that returns from bonds will come in short bursts of activity for the next several years, fixed-income ETFs would be a natural tactical vehicle for capturing the benefits of these rapid-fire returns.

Arbitrage

Fixed-income ETFs now join the over-the-counter (OTC) and the futures/swaps markets increasing the number of sources of fixed-income instrument pricing. Savvy investors are uncovering arbitrage opportunities, Tucker said, by actively looking for mispricings between the three markets.

Index Exposure

Most fixed-income ETFs are structured to track the performance of bond indices. For investors who seek a diverse portfolio of bonds available at low transaction costs, fixed-income ETFs are the only option.

Like tactical traders, some money managers want the majority of their portfolios to track the performance of an index — but they may disagree about the direction of a portion of the fixed-income market based on varying opinions about duration, economic views, and so on. Portfolio managers could therefore purchase a large proportion of their portfolios in a fixed-income ETF that tracks a preferred index. With the remainder of their funds, they could purchase specific bonds to adjust the portfolio to the desired exposure. In this way, fixed-income ETFs allow investment managers who have asset allocation competency, but perhaps not security selection competency, to take advantage of their skill set in a nimble fashion.

Perhaps the most important conclusion from Tucker’s presentation is that fixed-income ETFs are no longer a strange experiment causing anxiety for savvy fixed-income investors. Instead, these vehicles have expanded investors’ arsenals — and improved the bond market in the process.

Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Source: Fixed Income ETFs: A Primer