This podcast was recorded at Sage’s “Perspectives on the Future” Conference, a two-day event in Austin, Texas, that featured diverse thought leaders on geopolitical events, investment strategy, risk management, retirement policy and issues, women and investing, and sustainable investing.

Here is the transcript of the podcast recorded on 11/18/2019:

Sage Advisory: Hi everyone, I’m here with Karen Schenone from BlackRock. She is a fixed income strategist and she is speaking today at the Sage Conference on ETFs, and the growth of bond ETFs, more specifically. So Karen, thank you very much.

Karen Schenone: Thanks for having me today, Simon.

Sage Advisory: Karen, given that you’re such an expert in fixed income ETFs, you’ve got a great view of the industry given where you work, perhaps you can give us an update on where we are in terms of bond ETFs at the moment, and you know, how you see the future.

Karen Schenone: Sure, in bond ETFs today, we’re seeing more and more investors discover them for the first time. We’ve had bond ETFs out since 2002, so we’re 17 years into the growth of this particular part of the industry. And globally, we’ve just had a milestone in 2019, where we’re now over a trillion dollars in global assets under management and bond ETFs. And we continue to see new investors, institutions, and private wealth managers starting to use them for the first time.

Sage Advisory: That’s great. So, what’s driving this growth?

Karen Schenone: We’re noticing several trends. The first is that the bond market has really modernized. We’re seeing the growth of electronic trading, more people thinking of getting exposure through vehicles rather than through individual bonds. We’re seeing more institutional client adoption – so asset managers, pension plans, even hedge funds utilizing them. And we’re seeing more people using them as portfolio construction tools. So alongside individual bonds, as well as derivatives, people are using bond ETFs to gain access to very specific parts of the bond market.

Sage Advisory: Now, why are they doing that and how does that work?

Karen Schenone: Yeah, I think that in the past you had to build portfolios in two different ways; you either had to hire an active manager and outsource some of the decision making, or you had to build a portfolio bond by bond. Now with the bond ETF, because most of them are designed to track an index that follows a very specific part of the bond market, you can now put together an investment grade credit portfolio, you can adjust the duration, you can access parts of the market like emerging market debt in a way that you just couldn’t before. So now we’re seeing people utilizing ETFs as really the building blocks in order to build very targeted bond portfolios.

Sage Advisory: Okay, that’s interesting. Another area that seems to be growing is bond indexing. Perhaps you can tell us a little bit about that and how it’s grown relative to the equity markets, which I believe the equity index market is some years ahead of the bond index market. But perhaps you could tell us about that and why bond indexation has taken longer?

Karen Schenone: Yeah, I think for most people they don’t really think about indexing and bonds going together. But we’re seeing more people want to utilize index exposures. And I think you’re exactly right, Simon, we’re seeing so many people who are comfortable with indexing on the equity side, it’s really the language of how they express views and think about equities that has really developed. And in fixed income, we’re kind of 20 to 30 years behind the growth and acceptance. So just putting some numbers to it; there’s about 24,000 bonds out there, and there’s about 3,500 bond indices. So, we’ve definitely sliced and diced the market in different ways. But equity indexing is so much more developed; there are only about 8,500 stocks out there, but there’s almost 200,000 equity indices. So, I think people are used to being more precise and targeted with their equity exposures. And as people gain familiarity, and look at ways to be more precise with bond investing, we’re seeing the rise of indexing and fixed income as well.

Sage Advisory: I couldn’t finish this podcast without speaking about liquidity in ETFs in general, and more importantly for today, about bond ETFs. So, what’s the liquidity situation with fixed income ETFs at the moment, and how’s that changed over time? And what do you see for the future?

Karen Schenone: Yeah, we’re seeing bond ETFs becoming more and more liquid. As there are more investors trading them on the exchange, we see the average daily trading volumes have been increasing about 30% to 40% year over year. And why is that? Well, part of it is that the bond market is still an over-the-counter market where it’s very much dominated by large broker dealers and large investors. And if you’re a small investor, it can be difficult to go out and get liquidity. But when you bring an ETF onto the exchange that holds these bonds, you’re now able to trade them in the same way that you would trade equities. And that has a lot of information and it has a lot of power because now everybody’s on a level playing field. And we tend to see that you can trade the ETF intraday if you have to; whereas the bond market, especially post-financial crisis, has become a little less liquid. It takes longer to get bids on bonds, it takes longer to sell them. And so institutional investors in particular are utilizing ETFs as a way to add some liquidity to their bond portfolios.

Sage Advisory: So, is the liquidity factor one of the main drivers behind the growth in bond ETFs or are there other reasons why institutional investors are moving towards bond ETFs?

Karen Schenone: Definitely, we see three primary reasons. First is liquidity; where they want to pair them alongside individual bonds as something they can sell quick. Then the next is just ease of use, just the operational efficiencies. For example, we’re speaking with investors who maybe don’t have a mortgage trading desk to buy mortgage bonds, but they can access MBB, our mortgage-backed securities ETF, just as easily as they could any stock. So, I think that operational efficiency is really coming in handy. And the final reason is just low cost. I think in a lower-yield environment, costs become a more important factor. So, I think the low-cost nature of a bond ETF is driving people towards usage.

Sage Advisory: Excellent. Just in finishing, what do you see going forward? What are the new things, new trends, and perhaps new announcements that might take place in 2020 that people should look out for?

Karen Schenone: I think people will see a few different trends, really around the portfolio construction topic. Investors are really delving into the sources of those returns. And that really speaks on the equity side to factors. And those are persistent drivers of returns across portfolios and in fixed income and ETFs in particular, we’re looking at how do we strip out more the factor exposures, mainly interest rate risk and credit risk. So, you’ll probably see more factor ETFs, as well as more term maturity ETFs. These are ETFs that actually mature like a bond. So, I would expect to see more of those as people are utilizing ETFs in a way that they would individual securities as well.

Sage Advisory: Well, thank you very much.

Karen Schenone: Thank you so much.

This article originally appeared on ETFTrends.com.