For 17 years, time stood still for my husband and me. We didn’t age a bit as we globe-trotted, mountain-climbed, and ran marathons. Then we had kids. Time now stares back at us through our children’s eyes, and I realize that change happened gradually–and then all of a sudden. This is often the case in life.
That same pattern of “slowly and then all at once” is true for the forces driving the bond markets.
Back in the late 1990s, I was an analyst on a large bond trading floor, clacking away on my trusty Monroe bond calculator. This breadbox-size machine had been a staple on trading desks since the early 1970s, and 25 years later I relied on a 10-year-old version. Even when the hardware finally disappeared for good, in the early 2000s, there were some bond veterans virtually clutching these security blankets as they were shown the door.
In those days, bonds traded largely by phone, with orders relayed over a firm’s internal intercom (the “hoot”). There were no recorded phone lines, and giving your word when saying ‘done’ meant everything. The trading floor was a cacophony of phones ringing, people yelling, and handsets slamming.
Visit a trading floor today and you will encounter a very different scene: The market for buyers and sellers has moved beyond one-on-one “over-the-counter” transactions. Phone calls, made on fiber optic headsets, are more likely to be about correcting an erroneous keystroke on an electronic trading platform than asking for a price on Treasuries. More and more, sales and trading desks are reorganizing and even merging with their equity counterparts to better cover clients and win new business. As a result, the bond markets are more competitive and transparent, with trades happening in seconds and typically at lower transaction costs.
Why it matters
While most investors never have to navigate the labyrinth of bond trading and market structure, it’s important to recognize that technology has profoundly changed how investment professionals and risk managers pursue their strategies on behalf of clients–not just big institutions but people like you and me.
The exchange traded fund (ETF) is another innovation that, alongside electronic trading, has brought more choice and clarity for investors. Their “wrapper” structure means that shares of fixed income ETFs are bought and sold on the open exchange just like stocks, providing an additional layer of liquidity and public transparency into pricing. The trading cost differential between individual bonds and bond ETFs can be substantial. For example, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) had an average bid-ask spread of .01% for 2018, while the average bid/offer spread of the underlying securities in LQD’s benchmark index (Markit iBoxx USD Liquid Investment Grade Index) was .40%–a difference of .39%. (Sources: BlackRock, Bloomberg Barclays, NYSE Arca, as of 12/31/2018.)
What’s more, as bond ETFs have grown–they currently represent about $650 billion of assets in the U.S.–investors increasingly turn to them as market proxies. We saw this clearly on display in 2018. Last year saw the second-best inflows on record, $98 billion for U.S. bond ETFs, and an outright record year in secondary trading volumes: the average daily trading volume of $8.5 billion was an impressive 41% increase from 2017.
But it was December that really delivered the message that something significant has indeed happened in bond markets. As equity markets swooned, and demand for bonds increased, bond ETFs stepped up and filled the liquidity gap. That month, they clocked in new record trading volumes totaling $273 billion, or an average of $13 billion a day, according to data from Bloomberg and BlackRock. Unless you’re a close market watcher, you probably didn’t even notice – which is exactly the point.
Where has the time gone?
These innovations in bond investing haven’t come from nowhere. Rather, they’re part of a secular trend of modernization that was hastened by the 2008 financial crisis, when bank balance sheets shifted–gradually at first and then suddenly. With new limitations on risk taking and higher funding costs, bank balance sheets look very different today than they did a decade ago.
What’s more, even with record amounts of corporate debt issuance, there is diminished inventory in a trader’s book and less than 30% of corporate bonds trading in the market on a given day. Not coincidentally, assets in bond ETFs have grown by 19% per year since the end of 2008 through the end of 2018, according to BlackRock.
People ask what is driving the growth of bond ETFs, and the simple answer is that more investors, from professional to individual and across more financial strategies, are realizing that these vehicles are not only useful, but important to their investing and trading strategies. So much so that the bond veteran who today tends only to individual bond positions may soon look like his Monroe-clutching predecessor.
Heather Brownlie is the U.S. head of BlackRock’s Fixed Income iShares.