Pension funds increase use of fixed income ETFs

Pension funds are increasingly using ETFs to gain liquid access to fixed income, according to industry experts.

Towers Watson senior investment consultant Christopher Sutton says a lot of UK pension funds have increased their allocation to corporate bonds over the last year. However, he explains liquidity only materialises at the new issue of a bond in many cases.

He says: "What we're increasingly seeing is rather than being hostage to those liquidity points, pension funds are using the ETF to buy the corporate bonds when they want to. They then move out of the ETF into underlying bonds as new issuance brings to market the type of bonds they require, in terms of the duration and credit rating."

iShares head of UK and Ireland institutional Philip Phillipides says ETFs are tradable on an intra-day basis, compared with the underlying bond markets which are over the counter (OTC), with no on-exchange pricing transparency.

He says: "The prices managers get in order to manage their own portfolios in fixed income will vary with their relationships and the size of the firm."

For example, he says larger managers are more likely to get better pricing and more of the available liquidity to manage their portfolios.

He adds: "For index funds like iShares, good pricing and liquidity is crucial to minimise tracking error and allow clients to go in and out of different exposures efficiently."

Evercore Pan-Asset Management chief executive Christopher Aldous says large pension funds with their own investment teams are likely able to do their own credit research on which corporate bonds they want to buy.

However, he explains unless a £50m-£100m pension fund has a specialist bond manager, there is a huge and confusing range of bonds from which to select.

Aldous says: "The corporate bonds ETFs we were buying had about 400 underlying bonds in them and gave us lots of diversification."

He says investors could have paid a 6% spread between the bid and offer on corporate bonds at the beginning of this year. He adds: "If you're buying a corporate bond ETF, the maximum spread allowed between the bid and offer price is only 3% in the UK market."