Bond ETFs Impacting Fixed Income Market: Fitch

Includes: AGG, BND
by: Tom Lydon

While corporate bond exchange traded funds only make up a sliver of the $9.2 trillion U.S. corporate bond market, investors are more interested in using the fund investment vehicle to gain exposure to fixed-income assets.

According to Fitch Ratings, dealer inventories in investment-grade corporate bonds hovers around $9 billion as of the end of June. Meanwhile, the five largest investment-grade corporate bond ETFs have a combined $45 billion in assets.

High-yield bonds paint a similar picture, with related ETF assets around $28 billion, or four times the $7 billion in dealer inventories.

Fitch analysts, though, note that interest in Treasury and municipal bond ETFs remain less prominent. Treasury ETF assets have held steady at over $60 billion over the past few years, or 0.5% of the $11.3 trillion U.S. Treasury market. Muni ETFs have $13 billion at the end of March, or 0.35% of the $3.7 trillion muni securities market.

Moreover, Fitch points out that investors are turning to the ETF vehicle to quickly enter and exit fixed-income positions during periods of market volatility, particularly in high-yield bonds. The average trading volume on a weekly basis in the five largest high-yield corporate bond ETFs have tripled from $470 million in May to over $1.5 billion in June.

"This ramp-up in trading activity points to the utility of ETFs in allowing investors to rapidly enter and exit fixed income positions during a period of market turbulence," Fitch analysts said. "However, increased ETF trading volumes might also amplify overall bond market volatility, as redemptions of ETFs can, in turn, drive selling in the underlying bonds."

Bond liquidity concerns rose after investors started dumping fixed-income assets as benchmark 10-year Treasury yields rose 100 basis points from May.

"For context, recent Federal Reserve Bank of New York research indicates that an investor or dealer liquidation of more than $250 million in corporate bonds in one day could begin to adversely affect bond prices," Fitch analysts added.

Nevertheless, the ETF vehicle has helped bolster liquidity for investors interested in trading fixed-income assets, especially in high-yield corporate bonds.

"ETFs provide a mechanism for fixed income investors to trade more actively within the high-yield market, helping to compensate for the underlying bond market," Fitch said.

Max Chen contributed to this article.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.