A $15 Billion ETF Is Firing Up Wall Street’s Booming Bond Trade
(Bloomberg) — When Gilles Pradere saw a money-making opportunity to go long European credit in January, he decided against selling default swaps and rode one of this year’s hottest trades instead.
In so doing, the Geneva-based portfolio manager at RAM Active Investments was part of a flock of investors who have migrated to the 13.5 billion euro ($14.9 billion) product this year, spurring a record $5.5 billion of inflows.
Demand for the strategy is helping to spark technological innovation like electronic portfolio trading, bringing Europe closer to the livelier U.S. It’s also brought the size of the BlackRock fund relative to its underlying market closer to that of its more famous American cousin, the $35 billion LQD.
The ETF allowed Pradere “to get a very diversified exposure in one go as well as offering much better liquidity than individual cash bonds,” he said. At the time, he reckoned bonds were cheaper than swaps. He has since exited the trade for a profit.
With negative yields in safe assets triggering a hunt for returns in corporate bonds, the clamor for European credit has been at fever pitch all year. ETFs, along with other index-based products, allow investors to gain exposure to a basket of securities in a single trade.
They’ve been slow to make inroads in Europe, though. Thanks to a slew of structural impediments holding back ETFs, credit-default swap indexes remain the instrument of choice for managers seeking a liquid alternative to the cash market. CDS contracts give credit exposure to a basket of companies, while ETFs also have embedded interest-rate risk.
The growth of ETF assets in Europe is fueling hopes that it’ll add to the boom in portfolio trades, a newfangled strategy in which multiple bonds from different borrowers change hands in a single transaction.
While Goldman Sachs Group Inc. is said to have been involved since at least 2017, the practice has exploded recently. Bond desks on Wall Street have executed at least $88 billion of portfolio trades this year from virtually none two years ago, according to an analysis by Morgan Stanley.
“The growth of fixed income ETFs, custom basket trading and electronic trading are all interlinked,” said Vasiliki Pachatouridi, who leads fixed income strategy at BlackRock’s iShares. “Portfolio trades, similar to the idea of bond ETFs, are about harnessing fixed income beta exposures to manage the risk and liquidity of large scale portfolio transactions, which is increasingly difficult to do on a bond by bond basis.”
Despite its meteoric rise, IEAC still lags LQD in key respects. There’s effectively no lending market for the shares, making short-selling a challenge. Around 2.5% of LQD’s shares are sold short. Also virtually non-existent are options on the ETF, compared with a busy derivatives market for its U.S. counterpart.
Credit-default swap indexes remain a far more popular alternative to cash bonds in the region. IEAC’s proportion of overall assets in European corporate debt remains just 0.55 percent.
Nevertheless, the rise of the product has given the region’s portfolio managers like Pradere, who have long suffered from bond illiquidity, a powerful new trading tool.
“ETFs are a good intersection of mutual funds and derivatives. We see investors use them interchangeably for all intents,” said Chanchal Samadder, head of ETF product strategy at Lyxor Asset Management.