Investors have increasingly turned to exchange traded funds as their go-to investment vehicle of choice for fixed-income exposure as liquidity in the underlying debt market dries up, especially after the new banking rules.
For instance, investment-grade corporate bond ETFs attracted $7.7 billion in net inflows over the first nine months of 2015, according to S&P Capital IQ.
“While we think demand for high-quality fixed-income securities is strong, in light of modest Treasury yields, inflows have also been aided by actions banks have taken to reduce inventories of bonds Available for Sale,” Todd Rosenbluth, Director of ETF Research at S&P Capital IQ, said in a research note.
After the 2008 financial downturn, the Securities and Exchange Commission has enacted new rules for the banking sector. Specifically, banks have increasingly placed their holdings of bonds into held-to-maturity portfolios, with banks’ HTM portfolios up to 20.7% of all securities at the end of Q2 2015, from 17.5% year-over-year.
The HTM portfolios are not subject to quarterly mark-to-market adjustments, so they do not impact a bank’s capital levels the same way bonds available for sale are, which is an important difference as Basel III capital rules go into effect – under Basel III rules, banks are required to count gains and losses in the price of these securities as part of their Tier I common equity.
Erik Oja, S&P Capital IQ banking equity analyst, also found that banks like JPMorgan (NYSE: JPM) have to return excess capital back to shareholders over the past five years. Additionally, Oja added that the Volcker rule, which prohibit banks from proprietary trading such as certain speculative investment activities, has significantly diminished fixed income trading activity at major banks.
Consequently, due to these new rules, big banks have been hoarding debt and have become less active traders in fixed-income securities, which has led to diminished liquidity in the bond markets. According to iShares data, less than one third of the bonds in Markit iBoxx Liquid Investment Grade index traded on a daily basis during 2014. [Reviewing Junk Bond ETFs]
“In that context, we think for investors that want daily access to investment-grade corporate bonds, ETFs have been and in our view can continue to be a solution,” Rosenbluth added.
For instance, the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEArca: LQD) trades intra-day more than 3 million shares. Other actively traded ETFs include the iShares 20+ Year Treasury Bond ETF (NYSEArca: TLT) and SPDR Barclays High Yield Bond ETF (NYSEArca: JNK). According to MarketScope Advisor data, 20 taxable fixed income ETFs trade an average 500,000 shares or over on a daily basis.
Consequently, as investors find it harder to deal with individual debt securities, more are turning to liquid bond ETFs to weave in and out of fixed-income markets instead. [Junk Bond ETFs Liquidity]
For more information on the fixed-income market, visit our bond ETFs category.
Max Chen contributed to this article.