Bond ETFs Swelling in Europe as Trading Debt Gets Tougher

Bond buyers are pouring record amounts of money into exchange-traded funds in Europe that buy debt as central bank largess boosts demand and makes investors less willing to part with their fixed-income assets.

Investors deposited more than $16 billion into ETFs that purchase debt from high-yielding corporate notes to sovereign bonds, almost quadruple the amount in the same period last year, according to data compiled by Bloomberg. BlackRock Inc., the world’s biggest provider of ETFs, estimates bond-fund inflows will climb to about $20 billion by year-end.

The unprecedented era of near-zero benchmark interest rates that’s fueling demand for debt shows no signs of abating in Europe, with European Central Bank President Mario Draghi pledging to keep borrowing costs at record lows for an extended period. Deposits into bond ETFs across the region are growing twice as fast as flows in the U.S. as Federal Reserve Chair Janet Yellen said rates in the world’s largest economy may rise sooner than it currently envisions if the labor market improves.

“ETFs tend to introduce liquidity into the market and are particularly attractive to investors where bonds are less frequently traded,” said Peter Sleep, London-based senior money manager at Seven Investment Management LLP, which manages more than $10 billion. “They offer much greater transparency than is available in the bond market and shine a spotlight on the pricing of bonds.”

‘Underlying Fragility’

Lack of buying and selling in Europe’s bond market was highlighted as a concern by the ECB and the Bank of England in their latest stability reports. The BOE said “an underlying fragility” prompted by banks pulling back from market making could roil markets should investors simultaneously try and unwind their positions.

This year’s $16 billion of bond ETF deposits in Europe compares with just $4.5 billion in the same period a year ago, data compiled by Bloomberg show. Flows into U.S. funds grew to $23.8 billion this year, a 58 percent increase.

Investors piling into ETFs as a faster way to trade corporate bonds may still be vulnerable. The funds can be as expensive to trade as the underlying debt when interest rates rise and there is a rush for the exit.

Bond Loss

High-yield bonds in Europe are poised for their first monthly loss since June 2013 after yields fell to a record low 4.12 percent in June, Bank of America Merrill Lynch index data show.

“ETFs might be very liquid when things are going well, but if markets get really ugly the ETF will only be as liquid as the underlying bonds it tracks,” said Christoph Fick, Munich-based senior money manager at Pioneer Investments, which oversees $241 billion.

ETFs were introduced in the U.S. 21 years ago and almost always track an index. They offer the diversity of a mutual fund and the tradability of a stock because they’re quoted on exchanges. The market for ETFs has ballooned to 5,217 funds with $2.63 trillion in assets from about 106 funds handling $79.4 billion in 2000, according to BlackRock.

European credit ETFs attracted $4.4 billion in 2007 when the ECB’s key rate was 4 percent, data compiled by Bloomberg show. The rate was cut to 0.15 percent last month amid a raft of measures aimed at stimulating the region’s economy, including a targeted long-term loans program giving cheap cash to banks.

‘Vehicle of Choice’

“More people are going overweight fixed income now given record low rates,” said Allan Lane, London-based managing partner of fund manager Twenty20 Investments, who has also worked in the ETF businesses of BlackRock and Barclays Plc. “The vehicle of choice is going to be ETFs because you don’t need an army of traders to move your portfolio around but you can have access to a whole market segment via a single ETF.”

Investors poured $1.4 billion into the iShares Core Euro Corporate Bond UCITS ETF, which buys investment-grade corporate bonds, making the fund the most popular this year among 309 fixed-income ETFs tracked by Bloomberg.

Just behind was the iShares JPMorgan $ Emerging Markets Bond UCITS ETF, which purchases debt from Russia to Argentina and amassed $1.2 billion in new money.

The best-performing fund this year is the ComStage ETF iBoxx € Liquid Sovereigns Diversified 25+ TR UCITS ETF, which has returned 19 percent, data compiled by Bloomberg show. Deutsche Bank’s db EUR Liquid Corporate 12.5 Listed UCITS Fund, is the best company debt fund, returning 18.4 percent.

Emerging Markets

The funds gaining the most favor invest in markets where bonds are less frequently traded and buyers have less confidence in the true price of the securities. Emerging-market debt ETFs were three of the seven most-popular funds by inflows, while a fund that buys junk bonds was also among the top seven.

“ETFs are a better reflection of what the market thinks and where the real price of a bond is,” said Nikolaos Panigirtzoglou, global market strategist at JPMorgan Chase & Co. in London. “For emerging market and corporate bonds, ETFs have become a price discovery tool and marker for investors and risk managers because changes in bond indices are less reliable when underlying bonds do not trade.”

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