Need for Liquidity Boosts Fixed-Income ETF Demand

Bond exchange-traded funds are taking on an increasingly vital role in institutional portfolios as regulations have forced global bond dealers to reduce their inventories and market-making activities.

Regulations have sapped liquidity from the bond markets, according to the results of a new study, “Bond Market Challenges Continue to Drive Demand for Fixed-Income ETFs,” from Greenwich Associates. Meanwhile, historically low interest rates are forcing investors to search for yield, while simultaneously preparing for a long-expected pick-up in rates and volatility.

Over the past 12 months, institutions’ need for liquidity has been a primary driver of fixed-income ETF demand. More than half of the institutions in the study that have experienced liquidity problems say these issues have had a direct impact on their investment processes. While institutions of all types have struggled with reduced liquidity in bond markets, ETFs have not suffered the same fate as other bond investment vehicles. Since 2008, bond ETF liquidity has grown more than four and a half times, or at an annual growth rate of 33%, according to Greenwich Associates.

Those dynamics are boosting institutional demand for ETFs. “Overall, 59% of fixed-income ETF investors in the study reported they have increased their usage since 2011, with growing numbers of institutional investors turning to ETFs as a liquidity enhancement tool,” says Greenwich Associates consultant Andrew McCollum.

Institutions also are turning to ETFs to more readily achieve fundamental investment goals. For the past several years, investors have been adjusting portfolios in response to historically low yields, the potential for a prolonged rising rate cycle and to better weather spikes in volatility.

“As institutions shorten duration, diversify portfolios and seek out sources of attractive return by shifting assets to specialized and niche investments, they have found ETFs to be highly flexible tools to address both long-term strategic and short-term tactical investment objectives,” McCollum says.

These trends seem poised to keep growth of ETF usage by institutions at robust levels in the years ahead. One-quarter of the institutions in the study—and 40% of the investment managers—plan to increase their use of bond ETFs in the coming 12 months.

This momentum is likely to continue as institutions revisit internal investment guidelines and limits that had previously capped investors’ use of ETFs. Given these factors, Greenwich Associates expects fixed-income ETF usage will continue to build as institutional investors meet the realities of a challenging fixed-income marketplace with new and broader allocations to this vehicle.

Between January and March 2015, Greenwich Associates interviewed 128 U.S.-based institutional investors about their use and perceptions of fixed-income exchange-traded funds. The respondent base included 37 investment managers (firms managing assets to specific investment strategies/guidelines), 27 registered investment advisers, 50 institutional funds (pensions, endowments and foundations), and 14 insurance companies.

The sample population comprised 60 current active users of fixed-income ETFs and 68 non-users in order to determine current and future use of fixed-income ETFs by active users, as well as the current reasons non-users don't actively use fixed-income ETFs and their expected future interest.