Understanding the growth and acceptance of bond ETFs

February 19, 2019

 
Rich Powers

Rich Powers

A conversation with Rich Powers, head of Vanguard ETF® Product Management, on how and why bond ETFs have come of age.

It seems as though every ETF-related conference or forum nowadays touts the growth of bond ETFs. Is this a real trend, and what's behind it?

Yes, we can attest to the consistent growth of assets in bond ETFs. Over the last three years, U.S.-listed bond ETF assets have grown from $348 billion to $652 billion (see chart below). And in those 36 months, zero months had negative cash flow. There are now more than 350 bond ETFs, 70% of which follow an index strategy.1 ETFs aren't just the future of fixed income portfolio construction—they're a force to be reckoned with today.

What's driving this growth?

It’s due to three things:

  • Investors increasingly are realizing that indexing works just as well in fixed income as in equities—particularly because of its low cost hurdle in a low-yield environment.
  • Also, investors have gotten comfortable with the liquidity of bond ETFs, and new types of institutional investors in bond ETFs have driven growth.
  • Finally, investors and advisors often use fixed income ETFs to target particular sections of the fixed income market to target duration and risk.

Growth of U.S.-listed bond ETF assets (in billions)

Growth of U.S.-listed bond ETF assets (in billions)

Source: Morningstar, Inc.

You say investors are becoming comfortable with bond ETF liquidity. Can you explain that a bit more?

It's no secret that some bonds don't trade very often or, sometimes, very cheaply. Long-dated corporate bonds have a liquidity cost score (LCS)2 of 110 basis points, for instance. Investors aren't off base in at least asking how an ETF that trades throughout the day can own bonds that simply may not trade. But remember that ETFs are securities that trade on the market themselves. And 80% of the trading in bond ETFs is from one ETF holder to another—the underlying bonds aren’t even touched in those cases. When underlying bonds do need to be bought or sold to facilitate an ETF creation or redemption, most managers of the largest ETFs ask for only a small, fairly liquid, and statistically representative subset of the whole portfolio to be delivered by the authorized participant. So going back to the 110-basis-point LCS for long corporate bonds, we see, on the other hand, that the LCS for Vanguard Long-Term Corporate Bond ETF (VCLT) is a spread of only about 6 basis points.

Is bond indexing much like equity indexing?

Bond indexing is a bit more complicated. As mentioned, some bonds don't trade frequently. If a benchmark includes a bond that doesn't trade frequently or is snapped up in its entirety by, say, a pension fund at issuance, you might wonder how an index fund buys its requisite portion to track the index. Bond ETF managers employ a technique called optimization to seek to track corporate, mortgage-backed, municipal, and international bond benchmarks (and, to a degree, even U.S. government benchmarks).

To optimize, portfolio managers first identify the exposures in a benchmark that really drive performance. This would include the benchmark's duration, maturity bucket exposure, credit-quality bucket exposure, and issuer and sector exposures. They then build a portfolio that has exactly the same weights to those exposures, even if it includes fewer bonds. They're seeking to have a portfolio that matches each of those risk-driver weights—not only in the absolute but also in a matrix format. For instance, we'd want the portfolio weight of communication services sector bonds that are A-rated and in the 10- to 12-year maturity range to match the benchmark’s corresponding weight.

Investment process: Sampling vs. full replication

We strike the right balance between tracking error and the cost of investing.

We strike the right balance between tracking error and the cost of investing.

How do managers decide which specific bonds to pick?

Well, let's run with that previous example. Say the portfolio manager needs to maintain a hypothetical 1.5% weight in A+-rated, 10-year, communication services sector exposure. That manager could then fill that bucket with a bond issue from either Company A or Company B, even if both issues are in the benchmark. It'd be reasonable to expect that either issue would provide similar risk and return. But if Company B were trading too rich because of illiquidity, our traders could select the Company A issue instead. So we value our traders' input. Additionally, credit analysts may have an opinion on the long-term outlook for an issuer. For example, if their view were that Company B’s issue had a greater likelihood of performing differently from the benchmark, we would pick Company A to fill the slot. All else being equal, we want to hold all the issues in the same weights as the benchmark. But that's just not possible in much of the bond market. So understanding a team's expertise in applying the techniques we’ve just reviewed is important. Tight tracking is still achievable, but a lot goes into it. This is another example of how much human expertise and experience goes into indexing. Indexing at Vanguard is sophisticated. It is anything but turning on the computers and letting them run. We understand how to do it because we’ve been doing it since the company started more than 40 years ago.

Are there any other considerations that advisors should keep in mind when picking among bond ETFs?

We always encourage advisors to start by thinking about what the right exposure for the portfolio is—be it short-term versus long-term duration or government versus corporate versus broad aggregate, for instance. Then the advisor should zero in on the ETFs that best provide that exposure.

Tips for choosing the right bond ETF

  • Determine the desired exposure.
  • Determine the way to obtain that exposure.
  • Is there a low-cost alternative?
  • Is the ETF’s liquidity sufficient?
  • What is the ETF’s tracking error?

It certainly seems that while bond ETF investing is growing and important, there’s more than meets the eye.

That's exactly right. Advisors should keep the simple facts in mind: Bond ETFs offer the opportunity for low-cost, liquid, and predictable exposure. There’s homework to be done, but the outcome can be well worth it.

1 Morningstar, Inc., as of December 31, 2018.

2 Liquidity cost score is a bond-level liquidity measure that is defined as the cost of a standard, institutional-size, round-trip transaction, comparable to a bid-ask spread for the underlying bonds.

Check out the next article in the winter 2019 issue of ETF Perspectives.

Adam DeSanctis

Busting two myths about bond ETF liquidity

Adam DeSanctis, an analyst on Vanguard U.S. ETF Capital Markets Team, notes that given bond ETFs’ growing popularity, a bit of myth-busting is in order.

Notes:

  • Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
  • All investing is subject to risk, including possible loss of principal.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
  • For more information about Vanguard funds or Vanguard ETFs, visit advisors.vanguard.com or call 800-997-2798 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.

 

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