Central banks made a huge leap towards direct market intervention in 2020. Central banks in all developed markets added direct purchases of corporate bonds to their quantitative easing (QE) programs. As of December 1, 2020, the European Central Bank (ECB) and the US Federal Reserve held € 250 billion and € 7 billion in corporate bonds in their respective balance sheets.
Although these holdings are not as large as the total government debt, the way the Fed handled this monetary policy intervention was fancy. It bought about 6% (AUM) of total assets managed under the U.S. Corporate Bond Exchange-Traded Fund (ETF) and outsourced the execution to Blacker.
This is the latest example of how by-side credit market participants have evolved since the global financial crisis (GFC). Over the past decade or so, the buy-side structure has become highly centralized, so much so that today the world’s top five asset management firms command more than 27% of the global credit AUM.
At the same time, regulatory efforts to discourage excessive risk-taking by financial intermediaries have limited the latter’s ability to supply market liquidity. At the same time, lower interest rates and the purchase of central bank bonds have increased the issue of corporate bonds, which has made the need for liquidity benefits more important than ever.
As a result, many market participants have turned to ETFs. Why? Because they believe that investing in many index-tracking securities can provide an alternative source of intra-day traded instrument-ETF liquidity.
Such thinking is flawed. Investment in these securities has grown significantly in the ETF market and has established a new and larger type of by-side investor in the form of ETF sponsors. But this investor’s investment motives or incentives may not be the same as his traditional thematic by-side competitors.
Corporate bond market buy-side structure
For many years, the credit market has been notoriously at risk of issuer density. The investment-grade financial sector (IG) and high-yield (HY) energy sector represent more than 15% and 20%, respectively, each of these risks in the global market.
But while the issuer’s approach is critical for risk assessment, investors should also consider the buying-direction of the market.
The current buy-side structure of the global bond market is difficult to describe objectively. Bonds are sometimes held directly by non-financial institutions or liable investors who do not always publicly report all their holdings. As an example, data from the Fed’s Flow of Funds shows that investment funds hold about 30% of the corporate and foreign fixed-income assets held by U.S. companies. Insurance companies are the largest owners of these assets with a total of .5.5% shares as of 311 December 2020.
This helps explain why the effects of buy-side density and the consequences of the structure of the corporate bond market have so far been largely ignored.
To evaluate these trends, we used Bloomberg data to advise or directly compute the securities included in the ICE-BofA Global Corporate and HY Index to create an aggregate view of all investment firms. This universe of 2,847 investment management firms covers 33% of the total global IG and 41% of the global HY index. Our analysis confirms a material concentration towards investors: 45% of IG and 50% of the HY market are managed by the top 10 investment firms.
What explains this higher density? Mutual funds provide some insight into the universe. Mutual funds are the most actively traded entities and given their greater availability, they allow for more in-depth analysis. But corporate bonds are a viable investment for other fixed-income strategies, so the universe outside of corporate bond-centric mutual funds must be considered. For completeness, we have included so-called “aggregate” strategies in our analysis, along with corporate bond-centric strategies.
The chart below shows the range of buy-side concentration: the top three asset management companies represent 28% of AUM, while 90% of corporate bond ETF assets are managed by only three companies.
AUM concentration among management companies according to the type of funds
The role of passive investing in the bond market
Whether one views it as a passive investment or ETF investment vehicle, the market is currently operating in an oligopolistic framework that has a potential impact on the price structure, liquidity and active management industry as a whole.
Although the share of the total mutual fund industry AUM in the ETF sector began to grow before the GFC, it accelerated significantly after the crisis. Although in our analysis (including so-called aggregate strategy) 9% of the total funds ETFs, more than 25% of corporate IG-centric mutual funds are invested through ETFs, such as slightly more than 12% of HY-centric funds
Passive Fund (ETF) Share by Strategy at Fixed-Income Mutual Fund University
The rise of ETF investments in the corporate bond market is largely driven by the ability of ETFs to replicate the efficiency of a broad index and its exchange-traded characteristics. The latter quality eliminates price transparency issues and makes security accessible to a wide group of investors.
As GFCs and subsequent regulatory restrictions have been imposed on financial institutions, ETFs have become the main liquid instrument available for managing credit exposure to various investors. The share of ETFs in or out of asset class is even more impressive: over the last three to five years, Easy Corporate Funds accounted for about 50% of ETFs and 30% of HYs.
ETF shares of USD Fixed-Income Fund Inflow
The Fed’s decision to include these instruments in its epidemic-related QE program acknowledges this fact: the liquidity of corporate bonds depends on ETF trading conditions.
Yet analysis of US ETF equities and fixed-income universes shows that this premise is not entirely accurate. With the exception of the most liquid decile of Treasury funds, fixed income ETFs appear to be two to five times less liquid than their equity portion. This helps to further explain the need for Fed intervention in the corporate bond market in 2020.
Maximum discount on NAV for US-listed ETFs, average of diesel, December 2019 to December 2020
Extreme market environments, such as the March 2020 crisis, remind us that when ETFs are a trading instrument, there is no guarantee that the underlying securities are free from liquidity pressures. Conversely: the higher concentration among ETF providers – within the ETF replication algorithm – also tends to focus on trading pressures on specific bonds. When ETFs are under selling pressure, they often trade and carry higher volatility as well as higher liquidity costs.
Of course, ETFs are not without costs for vehicle investors. These are most neglected with the issuer’s risk density underlying the general premium and debt-based corporate bond index of ETF bonds. For this reason, corporate bond ETFs do not collect full market risk premiums in the long run.
In this context, it is necessary to acknowledge the oligopolistic market structure that has been created due to the influence of ETFs.
In the second part of our analysis, we will highlight its implications for investors to generate alpha from the fixed income market and consequently to build a portfolio.
If you liked this post, be sure to subscribe Entrepreneurial investors.
All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.
Photo Credit: © Getty Images / Halans
Professional education for CFA Institute members
Members of the CFA Institute have the ability to earn self-assessment and self-reporting professional education (PL) credit, including content Entrepreneurial investors. Members can easily record credit using their online PL tracker.