Vanguard, BlackRock Seen as Forced Buyers in Fed's Bond RetreatBy
QE runoff means U.S. will boost issuance as Fed demand wanes
Passive funds will buy Treasuries as index weighting increases
Looks like Vanguard and BlackRock will be buying more Treasuries whether they want to or not.
As the Federal Reserve finally starts to trim its mammoth crisis-era debt holdings, the two investment giants, both leaders in index funds, will almost certainly have to buy more to keep up with various bond benchmarks, analysts say. That’s because as the Fed pulls back, more debt issued by the U.S. government will end up in the market, prompting index providers to count the securities. (By convention, anything held by the Fed was excluded.)
Vanguard and BlackRock, in other words, will become forced buyers. Precise numbers are hard to come by, but what’s clear is that this oft-overlooked fact about passive investing may help keep a lid on borrowing costs as the Fed relinquishes its role as the biggest buyer of Treasuries. In the U.S. alone, over $1 trillion in bond funds track indexes. So as more Treasuries get added, the funds will automatically ramp up their purchases to match them.
“The concern is that as the Fed steps back there will be less support for Treasuries,” said Adam Phillips, senior money manager at Taplin, Canida & Habacht, which oversees more than $10 billion. “But you have a forced buyer -- a systematic buyer in these passive funds -- that will actually smooth the move higher in rates.”
In the past two months, Treasury yields have jumped on the back of a stronger U.S. economy, talk of a possible new Fed chair and prospects of higher interest rates. Some are breathlessly calling it a make-or-break moment in the $14.2 trillion market as 10-year yields briefly pushed past 2.4 percent. Today, the yield was 2.37 percent.
Analysts say the vast majority of passive bond funds are pegged the Bloomberg Barclays indexes. Its benchmark U.S. Aggregate Bond Index currently has about 37 percent allocated to government debt. That figure would rise to 44 percent if the Fed disposed of all its $2.5 trillion of Treasuries. (Most estimates, though, suggest the Fed won’t go that far and will retain a sizable chunk.)
Below is a breakdown of the Bloomberg Barclays U.S. Agg:
Before this month, the Fed maintained its investments -- comprising more than $4 trillion in Treasuries and mortgage-backed securities -- by buying new securities from the government to replace any maturing debt. The holdings weren’t included in indexes because they just sat on the Fed’s balance sheet, locked away from the investing public.
Now, that’s changing. This month, the Fed began letting some securities come due without buying new ones. Because the U.S. runs a deficit, the Treasury will need to boost issuance to investors to offset the shortfall.
The shift will have big consequences for firms like Vanguard. The pioneer of low-cost index funds has about $600 billion of its assets parked in passively managed fixed-income portfolios.
“When you are an index manager, you are all about tracking the benchmark,” said Josh Barrickman, the head of fixed-income indexing Americas at Vanguard. “We try to be prudent in terms of how we adjust.”
BlackRock, which oversees $1 trillion in index-tracking products globally, disputes the idea its passive funds are simply forced buyers and says the firm uses a “thoughtful sampling process.” However, it doesn’t dispute the main goal of index investing -- generating returns by tracking indexes.
“The objective of our passive fixed-income ETFs is to track those reference benchmarks,” said Steve Laipply, the head of BlackRock’s fixed-income strategy for its U.S. iShares ETF business. “So if Treasuries rise as a percentage in the benchmark, then our funds will also likely reflect that.”
The popularity, and influence, of passive investing has grown by leaps and bounds, particularly as ultra-low interest rates made it harder for active managers to outperform. Almost 30 percent -- or $1.05 trillion -- of the $3.62 trillion universe of taxable U.S. bond funds is passively managed, according to Morningstar. In 2008, the funds had $167 billion in assets.
Analysts say the Fed will allow its assets to decrease by a third to roughly $3 trillion. Regardless of the final number, Pimco’s Scott Mather says the increase in passive demand will be noticeable.
“In the absence of anything else, this is a sort of a dampener on yields,” said Pimco’s chief investment officer for core fixed-income strategies. “It does mean that on a relative basis there is at least a pool of money that will be increasing its risk-free asset, Treasuries, at the expense of not buying as many mortgages and corporates. That trend seems pretty firmly in place.”
Mather says there’s at least another trillion dollars of passively managed assets within corporate pensions and insurers that will be “moving in the same direction” and buying more Treasuries.
Depending on things like fiscal spending and monetary policy, Mather says Treasuries could make up 40 percent of the Bloomberg Barclays index within four to five years, which would compel funds pegged to it to raise their stakes as well. That might rise even higher if deficits worsen more than currently projected as a result of President Donald Trump’s efforts to cut taxes and lift infrastructure spending.
Still, index funds aren’t the answer to everything. Debt supply is still going to go up, interest rates (at least for now) are headed higher and there are plenty of investors who see a stronger U.S. economy pushing up bond yields.
“Yes, indexers will have to buy, but they are still not the majority of the universe” of fixed-income investors, said Subadra Rajappa, the head of U.S. rates strategy as Societe Generale. “It won’t overwhelm the market enough to prevent yields from rising overall.”
Jack Malvey, the longtime global fixed-income strategist at Lehman Brothers before it folded, isn’t ready to rule out the possibility that index changes can have a meaningful impact on prices -- even if it’s hard to know for sure. Malvey managed the team that ran Lehman’s bond benchmarks, which ultimately became the Bloomberg Barclays indexes.
“There is indeed an index-driven gravitational pull,” said Malvey, an adviser for the Center for Financial Stability. “As the Treasury share increases, it does mean that those investors that are index-matching will indeed have to increase their distribution of Treasury ownership through time.”