The difficult trading environment in bond markets is fueling the use of bond exchange-traded funds (ETFs) in institutional portfolios.
The 104 institutional investors participating in the Greenwich Associates 2016 U.S. Bond ETF Study are experiencing longer execution times, increased execution costs and more difficulty sourcing bond securities and completing trades—especially large ones. As they adjust their investment processes and portfolios to deal with these challenges, institutions are looking beyond individual bonds to alternative vehicles that can provide required bond exposures.
“Bond ETFs are emerging as an important alternative, and institutions are incorporating the funds into their process of rotating sector allocations, increasing or reducing risk levels and adjusting duration,” says Andrew McCollum, Greenwich Associates consultant and author of a new report “Institutional Investors Embrace Bond ETFs.”
The study found 68% of institutions have increased their use of ETFs over the past three years. Institutions are executing larger ETF trades. In 2015, only 19% reported executing a trade of $50 million or more. In 2016, that share jumped to 31%.
Thirty percent of the institutions are considering replacing individual bond positions with bond ETFs in the next year. Of institutions that use bond derivatives, 88% say they are considering or have considered using bond ETFs as an alternative. One-third of institutions plan to increase their use of bond ETFs in the coming year. Of these, 30% expect to boost ETF usage by more than 10%.
Investors’ need for liquidity has played a major role in driving institutional adoption of ETFs. Eighty-five percent of bond ETF users in the Greenwich Associates study name liquidity and low trading costs as main reasons for investing in ETFs. ETF usage rates have climbed to their highest levels in sectors experiencing liquidity challenges, including high-yield and investment-grade corporate credit.
Beyond liquidity, institutions cite a range of additional ETF benefits, including ease of use, operational simplicity, quick access, and speed of execution. As a result, they are employing the funds in an expanding list of applications ranging from managing cash positions and rebalancing to transitioning among investment managers.
“As a result of these trends, institutional use of bond ETFs will remain on a strong growth trajectory in years to come,” says McCollum.