Assets under management within fixed income ETFs are expected to double to $2 trillion within five years, according to a report from BlackRock, the asset manager behind the iShares brand of ETFs.

Rob S. Kapito, BlackRock President.

Global fixed income ETFs topped $1trn AUM in June 2019, a milestone that highlights how far they have come since the first ETFs linked to bonds were launched some 17 years ago.

The first bond ETFs began trading in 2002, roughly a decade after the first equity ETFs were introduced.

These trailblazing funds were the iShares 1-3 Year Treasury Bond Fund (SHY US), the iShares 7-10 Year Treasury Bond Fund (IEF US), the iShares 20+ Year Treasury Bond Fund (TLT US), and the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD US).

Fast-forward to today and these original four iShares ETFs hold more than $81 billion in AUM.

They have since been joined by more than 1,300 other bond ETFs, from dozens of different issuers globally, and are collectively gathering assets at an annual rate of 22% – more than three times the rate of open-end bond funds.

Rob S. Kapito, President of BlackRock, said, “Having spent more than 35 years in fixed income, I see bond ETFs as a game-changing technology because of how these products can bring convenience and transparency to a historically hard-to-access asset class. Their straightforward format – an ETF is bought and sold on exchange – lets investors manage diversified bond holdings simply and efficiently. Today, bond ETFs offer a rich diversity of exposures and good value…Taken together, these secular forces will accelerate the bond ETF market. All investors stand to benefit.”

Room for growth

BlackRock believes there is still plenty of room for growth and expects the pace of adoption to accelerate. It highlights four trends that look set to drive growth.

• Continuing evolution in portfolio construction

BlackRock notes that institutional and wealth managers are moving from a binary (active vs. passive, stocks vs. bonds, etc.) to a “whole portfolio” approach to portfolio construction. This new perspective focuses first on desired outcomes, then on asset allocation, and only then on the most efficient way to implement.

The report highlights that ETFs have been major beneficiaries of this mindset shift, reflected in the ever-expanding ways in which they are being employed in portfolio management. For example, bond ETFs are being used to build diversified portfolios based on low-cost index exposures, style factors (such as quality and momentum), and alpha strategies; fixed-term maturity bond ETFs are used to help generate predictable income through laddering; portfolio managers are using high-yield bond ETFs alongside individual securities in actively managed funds; and hedge funds are using ETFs for targeted long and short positions.

Meanwhile, cost and transparency have become key considerations for many investors, further driving the adoption of ETFs.

• Growing adoption by institutional investors

BlackRock notes that the increasing cost of capital since 2008 is leading institutions – pension funds, asset managers, and insurance companies – to rely on bond ETFs for quick, efficient market access.

Significant adoption by these investors traces back to 2008 when banks and broker-dealers pulled back from bond market-making amid market distress and its aftermath. With post-crisis regulation increasing the cost of capital, investors found trading volumes and liquidity were diminishing just when they were needed most.

In contrast, the report emphasizes how bond ETFs traded continuously on exchange throughout and after the crisis, providing large investors with a much-needed alternative.

Meanwhile, in Europe, the implementation of MiFID II has brought enhanced visibility to the depth of bond ETF trading. This, in turn, is driving further adoption of bond ETFs by providing fixed income investors the much-needed transparency in trading bond markets

• Modernization of the bond market

The report outlines how bond trading as a percentage of debt outstanding has declined in the post-crisis, dealer-centric world, as market participants look to ETFs and electronic trading to help improve liquidity. These forces are contributing to a universe of bonds that are priced and traded daily – a virtuous circle that supports the growth of bond ETFs.

BlackRock also points out that ETF market makers and authorized participants (APs) are becoming increasingly adept at managing bond inventories. Increased primary and secondary bond ETF trading by APs has enhanced underlying bond market transparency, liquidity, and real-time valuation methods. The bond ETF ecosystem has evolved to enable rapid pricing and execution of individual bonds and, importantly, bond portfolios.

• Innovation is opening new doors

Finally, the report highlights how new bond ETF exposures are adding convenience for investors, providing new tools for customization, and driving further adoption of fixed income ETFs.

In particular, BlackRock predicts growing demand for bond ETFs that incorporate environmental, social, and governance (ESG) factors into their methodologies, or target green bonds used to fund sustainable projects.

Additionally, BlackRock sees innovations in factor-based bond ETFs, providing investors with new ways to calibrate portfolios, for instance by helping investors balance credit and duration risk or selecting bonds according to financial traits such as quality and value.

Industry views

Conor Davis, EMEA Head of Investor Sales at Citi: “We welcome the growth of bond ETFs as a key way to improve liquidity in the underlying markets. Our research highlights that fixed income ETF ecosystem advances have set the stage for further significant growth over the next five years. We were early adopters of this trend and are pleased to support BlackRock’s continuing efforts to develop pioneering and innovative products for fixed income investors.”

Aymeric Paillat, Head of Global Credit Indices and Global Credit eTrading, JP Morgan: “Fixed income ETFs alongside other macro credit products have seen dramatic growth in the last five years as market participants continue to focus on liquidity and ease of execution. High correlation between individual credits, low default rates, and pressure on costs amplify this trend. As a result, JP Morgan continues to invest heavily in the fixed income ETF ecosystem, leveraging its strong fixed income franchise and risk capacity across execution, primary activity, options, and other services.”

Matt Berger, Global Head of Fixed Income and Commodities, Jane Street: “Jane Street was among the first firms to trade fixed income ETFs when they launched in 2002. Since then, we’ve seen a dramatic increase in the assets under management and trading volume of these unique investment vehicles. In just the last two years, we’ve seen a 50% increase in the dollar volume of trades. We regularly see single trades of more than $200 million for high yield and emerging market bond ETFs, and we’ve seen trades of more than $500 million for investment grade bond ETFs. To meet investors’ growing demand for liquidity, we’ve built out a dedicated team of more than 50 fixed income specialists across our primary offices in New York, London, and Hong Kong.”