Central banks took a huge leap down the road to direct market intervention in 2020. All central banks in developed markets added direct purchases of corporate bonds to their quantitative easing (QE) programs . As of December 31, 2020, the European Central Bank (ECB) and the US Federal Reserve held €250 billion and €46 billion of corporate bonds on their respective balance sheets.
While these holdings are not as massive as total government debt, the way the Fed conducted this monetary policy intervention was rather novel. It purchased nearly 6% of total assets under management (AUM) in U.S. corporate bond exchange-traded funds (ETFs) and outsourced execution to BlackRock.
This was just the latest illustration of how buy-side credit market players have evolved since the global financial crisis (GFC). Over the past decade, the buy-side structure has become highly concentrated, so much so that today the world’s five largest asset management firms control over 27% of global credit assets under management .
At the same time, efforts by regulators to discourage excessive risk-taking by financial intermediaries have limited their ability to ensure market liquidity. Simultaneously, low interest rates and central bank bond purchases have inflated corporate bond issuance, making the need for liquidity facilities greater than ever.
As a result, many market players have turned to ETFs. For what? Because they believe that as intraday traded instruments invested in many index securities, ETFs can provide an alternative source of liquidity.
Such thinking is wrong. Investing in these securities has dramatically increased the importance of ETFs in the market and created a new type of large and important buy-side investor in the form of the sponsor ETF. But that investor may not have the same investment goals or incentives as their traditional buyer counterparts.
Structure of the buy side of the corporate bond market
For many years, credit markets have been notoriously exposed to issuer concentration risk. The investment grade (IG) financial sector and the high yield (HY) energy sector represent respectively 15% and more than 20% of the risk of each of these markets worldwide.
But while the issuer’s perspective is key to assessing risk, investors should also consider the buy side 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 entities or by responsible investors who do not always publicly declare all of their holdings. For example, the Fed’s Flow of Funds data shows that investment funds total nearly 30% of foreign and corporate fixed income assets held by US entities. Insurance companies are the main owners of these assets with a 37.5% share of the total as of December 31, 2020.
This helps to explain why the effects of buy-side concentration and the consequences for the structure of the corporate bond market have so far been largely ignored.
To assess these trends, we used Bloomberg data to construct an aggregated view of all investment firms advising or directly holding securities included in the ICE-BofA Global Corporate and HY indices. This universe of 2,847 management companies covers 33% of the total of the global IG indices and 41% of the global HY indices. Our analysis confirmed significant concentration on the investor side: 45% of IG markets and 50% of HY markets are held by the top 10 investment companies.
What explains this increased concentration? The universe of mutual funds offers an overview. Mutual funds are the most actively traded buying entities, and given their wider availability, they allow for deeper analysis. But corporate bonds are eligible investments for many other fixed income strategies, so the universe beyond corporate bond-focused mutual funds must be considered. For the sake of completeness, we have also included in our analysis the so-called “Aggregate” strategies, as well as those focused on corporate bonds.
The chart below highlights the extent of buy-side concentration: the top three asset management firms account for 28% of assets under management, while 90% of corporate bond ETF assets are managed by only three companies.
Concentration of assets under management among management companies by type of fund
The role of passive investing in bond markets
Regardless of the perspective on passive investing or the ETF as an investment vehicle, this market currently operates in an oligopolistic structure with potential impacts on price formation, liquidity, and the active management industry. in its entirety.
While the ETF sector’s share of the mutual fund industry’s total assets under management began to rise before the GFC, it accelerated significantly in the aftermath of the crisis. Although ETFs represent 9% of all funds in our analysis (including so-called aggregate strategies), more than 25% of IG company-focused mutual funds are invested through ETFs, as well as slightly more 12% of HY-focused funds. funds.
Share of passive funds (ETFs) in fixed income mutual fund universes by strategy
The rise of ETFs investing in the corporate bond market is largely due to the ETF’s ability to effectively track broad indices as well as its exchange-traded characteristic. This latter quality alleviates price transparency issues and makes the stock accessible to a wide range of investors.
Since the GFC and subsequent regulatory restrictions on financial institutions, ETFs have become the primary liquid instruments available to various investors to manage credit exposure. The share of ETFs in flows into or out of the asset class is even more impressive: ETFs accounted for nearly 50% of inflows into IG corporate funds and 30% into HY over the past three to five last years.
Share of ETFs in USD fixed income fund inflows
The Fed’s decision to include these instruments in its pandemic-related QE programs recognizes this reality: the liquidity of corporate bonds depends on the trading conditions of ETFs.
Yet analysis of the US ETF equity and fixed income universes shows that this premise is not entirely accurate. With the exception of the most liquid decile of Treasury funds, bond ETFs appear two to five times less liquid than their equity counterparts. This helps to further explain the need for Fed intervention in the corporate bond market in 2020.
Maximum net asset value discount for U.S.-listed ETFs, average by decile, December 2019 to December 2020
Extreme market environments, such as that of the March 2020 crisis, remind us that while ETFs are exchange-traded instruments, this alone does not guarantee that the underlying securities are immune to liquidity stress. . On the contrary: the high concentration among ETF providers – among ETF replication algorithms – also tends to concentrate trading pressure on specific bonds. These trade more often and lead to more volatility as well as a higher cost of liquidity when ETFs come under selling pressure.
Of course, ETF vehicles are not without costs for investors. Most overlooked among these are those related to the general ETF bond premium as well as the concentrations of issuer risk inherent in the underlying indices of debt-weighted corporate bonds. For these reasons, corporate bond ETFs do not capture the full market risk premium over the long term.
In this context, the oligopolistic market structure that has formed under the influence of ETFs must be acknowledged.
In the second part of our analysis, we will set out the implications this has for investors seeking to generate alpha from bond markets and therefore for portfolio construction itself.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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