Looks Like A Bond, Trades Like A Stock

by: The Bid by BlackRock

Once upon a time, investors could only buy and sell bonds in the over-the-counter market. The exchange traded fund took bonds and made them as easy to own as stock ETFs. Matt Tucker, Head of America's Fixed Income Strategy, pioneered the bond ETF back in 2012. In this episode of The Bid, he explains how these low-cost vehicles have democratized investing and why he thinks they're only going to get more interesting.


Elizabeth Koehler: Most investors have heard of the Exchange Traded Fund or the ETF. But the phrase ETF often invokes visions of stocks or the traditional style box. Now Matt Tucker, Head of America's Systematic Fixed Income Strategy has a secret to share. Investors may want to pay attention to the stock ETF's lesser-known complement, the bond ETF. Bond ETFs have grown tremendously in recent years, and not just in global assets under management. On this episode of The Bid, Matt will talk about what makes bond ETFs unique and how they have changed the way that individuals, advisors and institutions invest. I'm your host Liz Koehler, we hope you enjoy.

Matt, thank you so much for joining us today.

Matt Tucker: Thanks for having me, Liz.

Elizabeth Koehler: You have the distinction of being the creator and portfolio manager of the first bond ETF back in 2002, so tell us a little bit more about your process back then. What inspired you to create the first bond ETF and why wasn't anyone doing this before?

Matt Tucker: Yes, I was lucky enough to actually be on the team and develop and launch the first bond ETF as you mentioned back in July of 2002. And if you go back and think about what was happening then, you had equity ETFs had been introduced a couple years prior, and you're seeing a real growth in usage. So investors were really discovering the benefits of being able to trade and invest in a portfolio of stocks that traded on the exchange. And we saw tremendous growth from this just as an investment vehicle, as a way to really empower investors out in the marketplace. And so we kind of thought about it and said, well what is going to be next? Well, fixed income ETFs, bond ETFs, probably have a role in a portfolio just like equity ETFs. Now, the challenge with bonds that a lot of folks don't understand is that bonds don't trade on an exchange; they trade over the counter. And what that means is that if you wanted to trade a bond you don't go up and pull up your listing from your broker. You can actually pick up the phone usually and call someone, and say, I'm looking for a bond, can I get it at the right price? It's a very manual process, and it means that there isn't a lot of price information available. So you want to launch an ETF, you've got to be able to have a basket of securities that you can actually price throughout the day, that people in the market can trade throughout the day. And those types of mechanisms just weren't available back then. So we had to do a lot of work to figure out just how to make the whole thing work, how to make the plumbing work to be able to support the trading of a basket of bonds throughout the trading day, which really had not been done before.

Elizabeth Koehler: We recently heard from Martin Small about how ETFs have really changed the way investors participate in the markets. We know most investors are pretty familiar with stock ETFs, as you referenced, so what are bond ETFs exactly and how are they different?

Matt Tucker: Well, if you think about the equity ETF, you basically have a bunch of stocks in a portfolio that is managed by a portfolio manager that trades on the exchange. And so as investors, we can all see that portfolio of stocks trading intraday, we can buy or sell that portfolio, much like we would an individual stock. And a bond ETF at that level is really the same thing. But what is really important is that that is very different from how most investors invest in the bond market. So if you want to trade bonds, you would have to go out and actually find a security, buy a security, the transaction costs can be very high. And it can be very difficult to actually find bonds and build diversification. And if you think about your options as an investor, you're like well if I want to invest in the bond market, traditionally, I could try to buy these individual bonds which is kind of cumbersome. I could try and go out and buy a mutual fund, and that can work, but you don't have the same level of control as an investor, you don't have the same level of transparency into your investment. And so an ETF really empowered individuals by allowing them to see their investment better, see it trade throughout the day, and allowed them to really create their own custom portfolio to rebuild their own fixed income portfolio, that aligned with their investment objectives and their goals. So it allows people to really personalize and invest in a way they couldn't do before the advent of the bond ETF.

Elizabeth Koehler: That's great. So it sounds like ETFs essentially take stocks and bonds from around the world, package them, and make them more accessible to everyone, and often times at lower cost. So with that context in mind, what are some of the potential benefits of bond ETFs in your mind, Matt? What do they offer that's different from other vehicles like individual securities or even actively managed funds?

Matt Tucker: I think you mentioned a couple of the benefits right there, and I think we just kind of think through them. This idea of intraday trading is very important to the bond market. Again, you simply don't have the ability to trade bonds with a great deal of ease intraday if you are most investors. Institutional investors might have the ability to actually access bonds at inventory, but for most people, you can't see it. And in fact, that is one of the other big benefits is that for most investors it makes the bond market visible for the first time. So intraday, everyone knows how to pull up an individual stock or the stock market and see what is happening, but if you think about it, most investors don't know how to pull up an individual bond or the price of a bond, or bond trends. And so ETFs are providing actually visibility into these markets intraday to give people a better sense of what is happening in the financial markets. And of course you have the traditional benefits of generally lower management fees on ETFs, relative to other investment vehicles. And of course there is the tax efficiency that ETFs often benefit from as well in many markets where they often times will deliver lower capital gains distributions than traditional funds.

Elizabeth Koehler: So Matt, you talk about how ETFs are able to invest intraday. Could that actually be seen as a bad thing if it's encouraging short-term investor behavior?

Matt Tucker: This is an interesting question that we get from time to time, and I think there is a misunderstanding of what intraday trading really means and what it enables people to do. So does it allow investors to trade more often if they want to? Of course. Is that generally a sound investment principle? For most people, not frankly. It's very hard to time the market short term. The real benefit of intraday trading for ETFs is a couple things. So one is it does provide you with a view into what the market is doing. People know what the stock market did today, but what did the bond market do today? ETFs help answer that question. And the second thing is that ETFs allow you to trade when you need to trade. So it's not the idea that you want to trade a lot but when you do want to rebalance your portfolio, when you do have new money to invest, when you do have some changing investment need that causes you to want to rebalance your portfolio, ETFs give you the ability to do that when you need to do that. And that again, that is such a critical feature in the bond market, where it can often be hard to trade individual bonds. So having an ETF that trades on the exchange, that is a collection of bonds, and still gives you the flexibility to trade when you need to trade, that is incredibly powerful.

Elizabeth Koehler: Thanks Matt, so let's go back in time a little bit to the financial crisis. How has the evolution of the bond ETF market paralleled changes in the bond market itself since the crisis?

Matt Tucker: I think it's a very timely question, obviously, as we're right now just about ten years since the depth of the financial crisis. If you think about the financial crisis broadly, it was a market where liquidity was challenging for a lot of asset classes, where a lot of investors had to really question their investments in different markets. But the really irony is that the financial crisis was actually a real boon for bond ETFs. If you take a look at the ETF market, around that time, what you saw was a number of different bond ETFs start to trade more readily and actually be utilized more as the financial crisis progressed. And what happened was, if you think about the financial crisis and in many ways, it was a bank and broker/dealer crisis. So, the intermediaries, the people that you actually would trade a bond with if you were to buy or sell a bond, many of those institutions either had gone out of business or were concerned they were going to go out of business. And so it became really hard for all investors, both individuals and financial advisors, even professional money managers, to actually buy and sell bonds. Liquidity became really challenging. And in that environment, many investors actually discovered the bond ETF. And they discovered it trading on the stock exchange, not in the traditional bond market. And so they suddenly found this alternate way to actually trade within the fixed income market and buy and sell baskets of fixed income securities. And so we saw for many bond ETFs an increase in usage, an increase in trading volume, and actually a growing number of investors as a result of the financial crisis.

Elizabeth Koehler: So rather than needing to buy hundreds of bonds in an index, which I would imagine would take quite a long time and be pretty costly, investors found another way?

Matt Tucker: That's right. And I think what it led to is increasing usage by institutional investors, even today. I think a lot of people start with the assumption that a bond ETF works for an individual or financial advisor, but you really wouldn't see a true institutional investor use a bond ETF. And in fact, the opposite is true. So very large, sophisticated institutions who have access to liquidity, to electronic trading platforms, to different derivative contracts like futures contracts, they will still use bond ETFs. Because ETFs have grown to be such a large and liquid market of the bond market that they provide liquidity and access to markets, and really convenience even for the largest most sophisticated investors in the marketplace.

Elizabeth Koehler: So how might individual investors adopt some of those best practices that we're seeing by these large institutions?

Matt Tucker: I think if you're an individual investor and you're looking to build a bond portfolio, what ETFs allow you to do is really customize your bond investment for your unique investment needs. So if you're an investor who is maybe in the later stages of retirement, you're focused more on income, there are a range of different bond ETFs that can provide income in different forms, let you build an income portfolio that is customized to you. If you're a younger investor and you're looking for a portfolio more based around diversification, one that you're looking to really balance out more risk investments whether those be stocks or real estate or something else, you can actually use a handful of ETFs to build a very diversifying portfolio that helps balance out your overall portfolio risk. So I think this is the real key about bond ETFs, and why it's really changed how investors behave, because it's democratized the bond market. And it's now empowered really all investors, whether you're individuals or financial institutions, to really invest in the bond market that really fits your specific investment objectives and needs, and really allow you to customize that exposure in a way you simply couldn't do before ETFs were introduced.

Elizabeth Koehler: Makes a ton of sense. Matt, if we could just move to rates for just a moment. So the Federal Reserve has hiked interest rates twice so far this year, and there are obviously expectations of two more potential hikes before the year is over. In this kind of a changing environment, how can investors be more thoughtful about cushioning their bond portfolios against risk?

Matt Tucker: So I think this is a great example of this idea of empowerment that I spoke about a minute ago. So in the face of what some investors might view as changing market conditions, so in this case, the Federal Reserve has hiked rates. So in that cycle, you have short-term interest rates that are rising, and many investors become concerned if those rising interest rates will cause a drop in the value of their fixed income investments. And so there are a number of things investors can do to try to position themselves in that kind of market. So one is they can invest in shorter maturity ETFs, the shorter maturity part of the bond market that is less sensitive to interest rate movements, meaning that as rates rise, it'll be less impacted in terms of price. We also have ETFs that have maturity dates. So you can actually go and buy a portfolio of bonds in ETF that actually matures on a future date. So in many ways, it's similar to buying an individual bond, but instead of buying one bond, say to five years in the future, you'd actually buy 50 or 100 bonds that all mature five years in the future. So, you get some of the same benefits of having a known maturity date like you do for a bond and an income stream, which a fund is going to look to pay out just like other ETFs would. But the investor knows they're getting diversification as well because they're buying a collection of securities inside the ETF and not an individual bond. And then the last one I'll mention, which has been a very interesting trade this year, has been the interest in floating rate notes that many people have, where the coupon rate on the bonds actually changes with changes in short-term interest rates. So as the Fed is hiking rates in the short end, the coupons, and therefore the income paid out by these ETFs actually is increasing. So floating rate notes have become a way for investors to actually participate in the Fed rate hikes and really turn the Fed hikes from being a concern about rising rates and impact on the portfolio to actually something that can cause an increase in the income they receive off their investment.

Elizabeth Koehler: Okay. One last question: what are some developments you see going forward both in the types of bond ETFs that will be offered, but also in how investors will be using them?

Matt Tucker: Well, if I sit here and look at where the market has come to, we're about 16 years since the advent of the first fixed income ETF. The market is now over $800 billion dollars globally, so it's grown to be very significant. There are fixed income ETF markets not just in the U.S., Europe, and Asia, but around the world. But in a lot of ways, we're still at the early stages of this adoption, which I think is fascinating. So if you think about the new types of funds that might be out there, you can go and invest in many individual segments of the bond market through ETF. But there are new concepts like, say, factor investing that are just now coming into the fixed income market. And so I imagine you'll be seeing more ways to invest in just different segments of the fixed income market, maybe more ways to invest outside the U.S. more in the global bond market. And at the same time, I think you're going to see more investors continue to become aware of and adopt ETFs. The ETF market in fixed income is still very small relative to the mutual fund market or the individual bond market. So there is a lot more space for investors I think to discover the benefits of bond ETFs and find ways to take advantage of many of those characteristics we talked about, the ability to actually see and invest in the bond market throughout the day, the ability to create portfolios that are really customized to that individual investor's needs in terms of the income profile or the diversification or whatever benefit the investor is looking to from their fixed income portfolio. So I still feel like there are so many investors discovering this market that we're likely to see continued interest and growth as we move forward.

Elizabeth Koehler: Matt, thank you so much for joining us today.

Matt Tucker: Hey, thanks for having me Liz, I appreciate it.

Elizabeth Koehler: And to our listeners, we'll see you next time on The Bid.

This post originally appeared on BlackRock.