The unprecedented demand for bond exchange-traded funds in the U.S. is spreading across the pond as European investors seek an easy way to buy into one of the longest bull runs in credit-market history.
The ETFs, which trade like stocks and can be purchased online, have attracted $35.7 billion this year worldwide, on track to exceed the record $84.9 billion placed last year, according to data compiled by BlackRock Inc. About $14 billion of that was in Europe, the data show.
Thirteen years after being created in the U.S., the funds are gaining traction globally as a salve for traders’ complaint that new regulations are making it harder to buy and sell bonds. While it’s simple to purchase an ETF, concern is growing that investors are underestimating how difficult it may be to get out when sentiment sours. The International Monetary Fund said in a report last week that the dynamic may pose a risk to financial stability.
“If times are good, ETFs can be more liquid than bonds because there is active secondary market trading, something which is lacking for bonds,” said Christoph Fick, Munich-based senior money manager at Pioneer Investments, which oversees $244 billion including ETFs. “But if everyone wants to get out of credit at the same time, owning the ETF won’t be an advantage.”
European bonds have handed investors seven straight quarters of gains as European Central Bank President Mario Draghi followed his 2012 pledge to do whatever it takes to preserve the euro with an asset purchase program that will see it buy about 1.1 trillion euros of debt. After expanding the scope of the acquisitions last month to include government bonds, yields on sovereign notes to corporate securities in the region fell to a record low of 0.46 percent, according to Bank of America Merrill Lynch’s Euro Broad Market Index.
Investors in the iShares Core Euro Corporate Bond UCITS ETF, Europe’s largest bond ETF, gained 1.61 percent this year, according to BlackRock. The fund holds investment-grade bonds issued by companies including Deutsche Bank AG to Enel SpA, according to data compiled by Bloomberg
Assets managed by fixed-income ETFs worldwide have ballooned to $459 billion from $431 billion last year and $354 billion in 2013, according to data compiled by BlackRock. In Europe, where bond ETFs were introduced in 2003, assets swelled to a record 103 billion euros ($109 billion) as of last month, up from 86 billion euros last year, according to Deutsche Bank.
Part of the reason for the surge in popularity is because it’s become increasingly challenging to buy corporate bonds outright in the aftermath of the financial crisis, according to Dorcas Phillips, executive director of ETF sales in Europe, the Middle East and Africa at Morgan Stanley.
“Being able to buy a tradeable security to provide you with exposure to an index of bonds is ever more valuable,” said Phillips, who is based in London.
Liquidity in credit markets has dropped by about 90 percent since 2006, according to Royal Bank of Scotland Group Plc. That’s because dealers have reduced the amount of their own money they’re using to make markets after new regulations made the businesses less profitable.
“There is currently a bottleneck in the corporate bond market as debt issuance has grown rapidly while the trading capacity of those bonds on the secondary market has decreased substantially,” said Vasiliki Pachatouridi, vice president of fixed income product strategy at BlackRock in London. “ETFs are increasingly being used as a complementary liquidity source.”
By granting cheap, quick access to less-traded securities, such as high-yield bonds or securities issued by companies in emerging markets, ETF investors could face a nasty surprise if there is a stampede for the exit, according to Howard Marks, the co-founder of Oaktree Capital Group LLC.
“People are going into the ETFs under the assumption, well, I can get out any minute,” Marks said in an interview with Bloomberg Television on April 2. “I think that’s always a terrible assumption.”
The ability of bond ETFs to function during periods of stress has also caught the attention of policy makers. The Financial Stability Board, which consists of regulators and central bankers from around the world, said last year it was examining whether ETFs based on assets that trade in less-liquid markets would be able to sell their holdings and honor all their obligations during a large withdrawal.
With the Federal Reserve Chair Janet Yellen saying last month she expects to raise interest rates this year, the bond market could be set for greater volatility, according to Bill Blain, a London-based strategist at Mint Partners Ltd.
“What goes up must come down,” said Blain. “At some point rates are going to rise and if you thought the bond-spike liquidity-vanishing moments we saw last year were extraordinary, you ain’t seen nothing yet.”