ETFs face the debt challenge

Corporate bond ETFs are increasing in popularity as investors seek yield amid a low interest rate environment. Yet index weightings are coming into question, as Emma Cusworth reports

The appeal of a transparent wrapper to access a market that trades predominantly over-the-counter (OTC) is clear. Corporate bond ETFs have gained traction among yield-hungry investors for this very reason.

Fixed income indexation has lagged other asset classes because of market complexity, poor pricing transparency and illiquidity. Corporate bond indices are not only hostage to these flaws, but their construction methodology and weighting have also come into question.

According to BlackRock figures, global fixed income ETF assets have more than doubled since 2008 to $218.4bn in March 2011. Last year saw European listings of corporate bond ETFs from providers including iShares, Lyxor and db x-trackers, among others. Historically low interest rates and Western sovereign default risk continue to underpin demand.

“In the low interest rate environment, there are opportunities to gain higher yields than traditional money markets offer, while preserving capital protection and maintaining a high degree of liquidity”, said Michael John Lytle, managing director at Source. “Taking a slightly longer investment horizon and a degree of credit exposure through corporate bonds can improve yields significantly and provide investors with a more attractive way to park cash they do not want to equitise or are not ready to invest for the long term. With US dollar Libor below 30bps these products potentially offer meaningful incremental yield.”

Liquid and transparent ETFs are an increasingly popular way to access fixed income, as a low-cost passive alternative to active funds with higher expense ratios. As Gary Mairs, joint CEO of TCF Investment, explained: “ETFs are the most attractive way of mainstream investors gaining exposure to corporate bonds. Before there was an issue buying corporate bonds in fund form, as they are all actively managed in one way or another, and buying direct was really difficult.”

However, fixed income indexation is far from straightforward. The market is harder to standardise, comprising around five million individual issuances of varying maturity, currency and credit rating. This compares with the universe of listed equities, which totals around 30,000. Furthermore, corporate bonds predominantly trade OTC, significantly decreasing pricing transparency and liquidity.

The lack of a clear system for bond price discovery makes valuing fixed income ETFs relatively difficult. “During the financial crisis, there were disparate views on corporate bond pricing,” said Nizam Hamid, Lyxor’s head of ETF strategy. “Clear pricing is important in terms of making ETFs’ NAV meaningful.”

Pricing issues
The dominance of OTC trading means the trustworthiness of the pricing source is a key consideration. Methodology varies among the most common benchmark indices. Pricing for the Barclays Capital Aggregate Bond index is 80% sourced from Barclays Capital traders. The Markit iBoxx indices use a consortium of up to 10 dealers.

“It comes down to the quality of the pricing source,” said Morningstar analyst Jose Garcia-Zarate. “Electronic trading platforms have improved things, but there still isn’t a 100% fool-proof pricing mechanism. I’m not sure there is a solution to this problem, it is a case of compromise.”