Insights on Exchange-Traded Funds

Sea change: Investor dollars are flooding into bond ETFs

Fall 2019

Key takeaways:

  • Awareness of ETF cost advantages has grown and adoption has increased
  • As adoption has increased, more and more specific subcategories of exposure have become available through additional product launches
  • A wider breadth of market exposures has given investors and their advisors increased flexibility and precision for portfolio construction
  • And the cycle repeats…

A massive sea change is underway in fixed income investing. Bond ETFs are supplanting both direct investment into single issues and actively managed bond mutual funds. In this article, we discuss the reasons this shift is occurring. We also consider how the evolving structure of the fixed income market coupled with a demographic tipping point could accelerate this move. What we are seeing now may only be a preview of a much more substantial migration toward bond ETFs in years to come.

Through the first half of 2019, more money was invested in bond ETFs than equity ETFs.1 This is the first time that net flows to bond ETFs have exceeded those to equity ETFs for this length of time. Bond ETFs now have over $700B in assets spread across more than 400 ETFs listed in the U.S. (see Exhibit 1).

Year-to-date flows in bond ETFs have been largely characterized by a reach for yield with a tilt toward higher quality. Ultra-short maturities were in demand at the start of the year, but inflows have trended toward longer maturities more recently. While some of this positive flow has likely come at the expense of equity exposure thanks to cyclical factors, we believe much of the influx is coming at the expense of direct single-issue bond purchases and actively managed bond mutual funds.

Age-old problems of access and pricing, remedied

Investors have long faced challenges with both access to and understanding of the bond market. Knowing where to buy corporate, municipal, or Treasury bonds, and what represents fair pricing and transaction costs—these are real hurdles investors still face. Bond ETFs make buying bonds as simple as buying a share of stock. Meanwhile, there is a growing awareness of the cost advantage of bond ETFs. What's more, today's vast selection of bond ETFs gives investors the ability to implement flexible and tailored exposure (see Exhibit 2).

Bond ETFs vs. bond mutual funds

Like many index mutual funds, bond ETFs tend to have low management expenses. They benefit from economies of scale and provide attractive diversification for investors. However, the ETF structure provides several critical advantages that are not available through a traditional mutual fund. These advantages include:

  • The ability to buy or sell shares throughout trading hours*

  • The potential for better tax efficiency

  • Daily transparency of portfolio holdings

ETFs vs. individual bonds

The advantage of an ETF is even more pronounced when compared to the costs and complexity of managing a portfolio of single bond issues. The difference is stark when we compare the average relative spread impact of buying and selling several core bond strategies using an ETF versus a direct investment in the underlying portfolio of bonds. For example, as shown in Exhibit 3, U.S. Aggregate Bond ETFs have historically traded at a bid/offer spread of approximately 2 basis points while the underlying portfolio's asset-weighted bid/offer spread is 14 basis points. The ETFs are often able to achieve a tighter bid/offer spread than the underlying portfolio of bonds. This is a result of the large volume of buyers and sellers that efficiently meet on the price-transparent stock exchange.

Bonds as a potential solution for retirees

The particular characteristics of bonds—coupon income, capital preservation, and the tendency to offset stock market movements—make them important in any diversified portfolio. But they are particularly relevant to investors approaching and in retirement. We believe the Baby Boomer generation will propel demand for bonds over the next 10 years, as this sizeable cohort experiences a more urgent need for sustainable income and a preference for capital preservation over the potential for capital appreciation (see Exhibit 4).

As retirees and near-retirees shift to higher bond allocations, they will encounter the challenges traditionally associated with bond investing— most of which relate to access and pricing. These impediments have historically led advisors to active bond funds or separately managed accounts, but this is clearly changing.

Further fuel for growth

In addition to the wave of Boomers entering retirement, there are two other developments that should further boost growth in bond ETFs. The first is a movement toward electronic trading in bonds. In the old days, bonds that hadn't traded in weeks would get back-of-the-envelope pricing. But the move toward electronic trading is finally pushing market makers to adopt proxy-pricing methods and trading techniques more like those already used in stock markets.

The second development is what is being referred to by the industry as the ETF Rule (or SEC Rule 6c-11). This is a formal codification of the existing disparate rules governing ETFs into a consistent, flexible framework under the Investment Company Act of 1940. The ETF Rule is likely to drive a more efficient creation/redemption mechanism in ETFs, which should translate directly into tighter ETF spreads and even broader product offerings.

A sea change, but still in early days

The marketplace for bond ETFs still trails the equity marketplace considerably. Among global equities, ETFs account for about $4 trillion in AUM, nearly 5% of the $83 trillion global equity market capitalization. Bond ETFs, on the other hand, only represent about $1 trillion, about 0.8% of the $96 trillion global bond market.1

But the significant trend of growing flows shows that investors are embracing the benefits of bond ETFs. The appeal of low fees has driven an explosion of new offerings. These have enabled investors to achieve similar exposures to individual bond portfolios, but with lower costs and more diversification. Compared with actively managed funds, ETFs often offer cost advantages and, in some cases, liquidity advantages. As the demographic trend of aging Boomers drives continued demand, we anticipate continued growth for bond ETFs for years to come.

About the authors

D.J. Tierney is a Managing Director and Client Portfolio Strategist at Charles Schwab and Co., Inc. supporting Charles Schwab Investment Management, Inc. (CSIM). In this role, he represents Schwab ETFs™ to sales channels, clients, and the media. He also works with CSIM's product team to optimize Schwab's ETF offerings. Mr. Tierney assists in managing relationships and communications for Schwab ETFs with authorized participants, broker-dealers, and regulatory agencies. Prior to joining Schwab in December 2016, Mr. Tierney spent 16 years with Morgan Stanley as a senior institutional sales, trading, and relationship management professional. Mr. Tierney earned a BA in economics from the University of California, Los Angeles, and an MBA from the University of California, Berkeley, Haas School of Business.

Christopher Johnson is a Vice President and Head of ETF Capital Markets and Equity Trading supporting CSIM. In this role, he is responsible for overseeing the Equity Trading Team as well as the implementation of all ETF capital market functions for CSIM, including managing relationships with authorized participants, market makers, stock exchanges and regulators. Mr. Johnson has been in the financial services industry since 1998, with experience in ETF trading, sales, and product management. Before joining CSIM in 2017, he was director and the head of U.S. ETF distribution at RBC Capital Markets, LLC. Prior to that, he served as vice president and head of ETF sales for the Americas at Macquarie Capital (USA), Inc. He also served as the director of ETF sales and trading at Cantor Fitzgerald and senior manager in international ETF product management at The Vanguard Group. Mr. Johnson earned a Bachelor of Arts in Asian studies-Japanese from Colgate University and a Graduate Business Certificate in finance from St. Joseph's University. In addition, he completed American Society of Pension Actuaries examinations C-1 and C-2 (DC). He holds Series 7 and 66 licenses.

Brian Chen is a Director supporting the ETF Capital Markets Group of CSIM. In this role, he monitors primary market activity and secondary market quality for the Schwab ETFs. Mr. Chen also manages relationships with authorized participants, market makers, stock exchanges and regulators. In addition, he partners with distribution channels to support and service Schwab ETF clients. Prior to joining CSIM in 2018, Mr. Chen spent more than a decade trading ETFs, bonds and related derivatives as a market maker and portfolio manager focused on arbitrage. Most recently, he was a director and the head of fixed-income ETF trading at RBC Capital Markets, LLC in New York. Prior to RBC, Mr. Chen worked for Citadel Securities, Bank of America Merrill Lynch, Del Mar Asset Management; and earlier in his career spent several years as a sell-side analyst at J.P. Morgan Chase. Mr. Chen earned a Master of Business Administration in finance from Columbia Business School and a Bachelor of Arts in both mathematics and economics from Northwestern University. He is a CFA® charterholder, and holds Series 7, 24, 53, 55, 63, and 87 licenses.

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