As of the end of 2019, mutual funds, money market funds, and exchange-traded funds (ETFs) held nearly $6 trillion in corporate, government, and municipal bonds, reflecting 16% of the U.S. bond market. As the credit markets faced unprecedented dislocation when confronted with the spreading of the COVID-19 pandemic, funds faced a record surge of redemptions.
With this recent dislocation, we share our observations on the role and the evolution of mutual funds and ETFs over the past decade, and the retail investors that invest in them.
What Role Can We Expect Fixed-Income Funds And ETFs To Play In The Credit Market?
Over the past decade, assets of fixed-income funds, including mutual funds, ETFs, and money market funds, have swelled, and they hold a growing share of the U.S. bond market. With this growth, these funds remain an important source of demand for bonds in both Treasury, corporate, and municipal bond markets.
These fixed-income funds play an important role in credit markets by improving the efficiency with which individual investors (or retail investors) can access the market, enabling diversification, and providing capital to the credit markets. However, the dramatic outflow of retail investor money over the past month points to the vulnerability of these funds to short-term redemptions. These redemptions, in turn, can contribute to rapid repricing of bonds, increasing losses and leading to wider market volatility. This will likely remain a topical theme as the current crisis continues to unfold.
How Did Mutual Fund Investors Respond To The COVID-19 Pandemic In March 2020?
In March 2020, investors withdrew nearly $140 billion from taxable bond mutual funds (and nearly $28 billion from municipal bond funds) in the U.S. These record outflows added to the pressure on bond prices during the recent credit market dislocations as fund managers sold assets to meet redemption demands (see chart 1).
These outflows marked a flight to safety and a rush to cash by investors, with retail investors adding $37 billion (and institutional investors pouring nearly $300 billion) into treasury money market funds during the month.
With this flight to safety, returns rose for Treasuries while falling for corporate and municipal bonds in March. While the S&P U.S. Treasury Bill Index was up 2.5% in March, the S&P Municipal Bond Index fell by 3%, the S&P Investment-Grade Corporate Bond Index Fell by 6%, and the S&P U.S. High Yield Corporate Bond Index contracted by 13%.
What Happened With ETF Redemptions During The Recent Market Dislocation?
During March's credit market dislocation, fixed-income ETFs kept trading under high volumes, even as corporate, municipal, and Treasury bonds faced days, or weeks, of secondary market illiquidity. Rapid sales of ETFs opened never-before-seen discounts of 5% or more between the net asset values and the prices of several of the largest corporate and municipal ETFs. In these cases, the liquid trading of the ETF appears to have provided price discovery on the value of the corporate and municipal bonds, where trading in the underlying bonds was limited by the gulf between bid and offer prices.
How Have Corporate Bond Funds Grown In The Past Decade?
The growth of corporate bond funds marks the most pronounced shift into fixed-income funds over the past decade. In dollar terms, assets of corporate bond funds and ETFs have increased by $1.2 trillion (more than a three-fold increase) since the end of 2009 (see chart 2).
With this accumulation of assets by mutual funds and ETFs, the share of the corporate bond market that is held through these funds has nearly doubled to 21% (from 11%).
Most of this increase has occurred as individual investors (also known as retail investors) have shifted away from holding bonds directly. In 2009, individuals' direct holdings of corporate bonds (where they would hold a bond outright, such as through a broker) amounted to near $1.9 trillion, but this type of direct holding has since fallen by more than 50%, to $938 billion by the end of 2019 (see chart 3).
Why Has The Growth In Corporate Bond Funds Been So Pronounced?
Over the past decade, there has been a structural shift as individual investors have increasingly chosen to invest in the fixed-income market through funds, rather than by purchasing bonds directly.
This trend has been especially pronounced in the corporate bond market, where bonds are much more difficult and expensive to trade for an individual investor than they are for an institutional trader (such as a bank, pension, insurance company, or mutual fund). Bonds commonly trade over-the-counter and in higher denominations, with less standardization, than equities. While the U.S. stock market has about 3,500 different stocks, the U.S. corporate bond market has more than 16,000 individual bonds. Furthermore, individual bonds trade with less liquidity and higher transaction costs than equities, and these costs are even more pronounced for small investors.
The U.S. Securities and Exchange Commission's Fixed Income Market Structure Advisory Committee (FIMSAC) conducted a study on retail notes, which are bonds from financial and nonfinancial corporates that are marketed directly to households and are sold in smaller denominations than institutional bonds. In the study, FIMSAC found that these retail notes traded less frequently, and with higher transaction costs, in the secondary market than institutional notes from the same issuer.
How Has Retail Investors' Exposure To The Overall Bond Market Changed In The Last Decade?
Despite this shift into funds, the share of the U.S. overall bond market (including treasuries and municipals in addition to corporates) held by retail investors has held relatively steady over the past decade.
Holdings of retail investors (estimated as the bonds held outright by individual households plus the bond assets of mutual funds, retail money market funds, and ETFs), represented 29% of the bond market in fourth-quarter 2019, matching the 29% share in fourth-quarter 2009.
However, the avenue through which retail investors hold bonds has changed over the past decade. In 2009, individual investors held nearly 19% of the bond market outright through direct purchases of bonds, and 10% of the bond market was held through funds. This mix has since flipped, with individual investors now holding just 13% of the bond market through direct purchases, while the share of the bond market held through funds has grown to 16% (see chart 4).
Have U.S. Treasury Funds Seen A Comparable Surge Of Retail Investment?
The size of the Treasury market grew by 115% over the past decade to close to $19 trillion as the federal government's deficit spending accelerated as a result of the 2008 global financial crisis. In tandem, assets held by government-bond-focused mutual funds and ETFs also increased, rising by 164% over the past decade. In addition to these Treasury-focused funds, Treasury bond assets also grew within the portfolios of many types of funds with broad mandates, including aggregate bond funds and balanced funds.
Even with falling interest rates and a growing economy, the low-risk income of treasuries has proved attractive for retail investors over the past decade In 2009, retail investors held 14% of the treasury market through a combination of their direct household bond holdings and through mutual funds and ETFs, and this share has increased by seven percentage points to 21% over the past decade.
Did Municipal Bond Investors Also Shift Investments To Funds?
Unlike corporate bonds or Treasuries, the majority of the municipal bond market is held by retail investors. Retail investors hold 76% of the municipal bond market through both funds and through direct bond holdings, and this share climbed by 10 percentage points over the past decade. Municipal bonds are tax-advantaged for individual investors, and this results in a traditionally high proportion of this market that is held by retail investors, in particular those high-net-worth investors seeking to minimize taxable interest income.
The largest share of the municipal bond market is held outright by investors (49%), and this share has increased by a percentage point over the past decade. Meanwhile, though a smaller share of the municipal market is held through funds, this share has expanded at a faster pace, growing by nine percentage points to 27% over the same period (see chart 5).
Are Investors Buying Lower Credit Quality Assets Through Funds?
Most corporate bond funds are primarily investment grade. Speculative-grade mutual funds are more specialized and are not as widely held. Investment-grade corporate bond funds and ETFs have nearly $1.4 trillion in net assets (as of year-end 2019 according to Lipper Refinitiv), while high-yield-focused mutual funds have $225 billion in net assets (see chart 5).
Do Assets Of Investment-Grade Mutual Funds Reflect The Ratings Distribution Of The U.S. Corporate Bond Market?
Credit quality of assets held by investment-grade funds generally mirrors the credit quality of investment-grade corporate debt in the U.S. There are more than 1,700 investment-grade-focused corporate bond mutual funds, and these funds have diverse mandates for portfolio allocations. To gauge the holdings of investment grade funds broadly, we looked at the distribution of rated bonds within S&P Dow Jones Indices' S&P U.S. Investment Grade Corporate Bond Index, and we compared this with the distribution of rated bond debt in the U.S. We found that ratings within the index closely aligned with the distribution of investment-grade bonds in the U.S.
The majority of investment-grade bonds in the U.S. are rated in the 'BBB' category, and this holds true in the index as well. A minor difference is the index has a slightly higher weighting of 'BBB' bonds at close to 55%, while U.S. corporate bond debt has a slightly lower share of 53% (see chart 6). This slightly higher weighting is offset by a slightly lower weight of 'A' category bonds.
How Do The Assets Of Speculative-Grade Mutual Funds Compare With That Of The U.S. Bond Market?
There are more than 500 high-yield corporate mutual funds. To compare the holdings of these funds with the broader market, we looked at the S&P U.S. High Yield Corporate Bond Index, which can serve as a benchmark for these types of funds. This index has a distribution of rated debt that approximates that of the U.S. speculative-grade bond market overall but with a few exceptions. In both the index and the distribution of U.S. speculative-grade bonds overall, the majority of the bonds are rated in the 'BB' category, the 'B' category is the second highest, and the 'CCC+' and lower category is the smallest. The index had a modestly lower weight in the 'BB' category, at 52% (compared with 57% of U.S. corporate speculative-grade bonds), and the index also had a slightly higher weight in 'B' bonds (at 34.9%, versus 31.4%) (see chart 7).
How Large Of A Market Do Bond ETFs Represent?
Bond ETFs are a small, rapidly growing, and fast moving piece of the market for fixed-income investment. Taxable bond ETFs have grown more than five-fold over the past decade, and this growth outpaced the three-fold growth for taxable bond mutual funds. After initially changing the landscape for equity investment, the shift in investor demand toward passive investing gained traction in fixed income in the past decade, contributing to the growth in these ETFs.
Even with this rapid growth of ETFs, corporate bond mutual funds remain considerably larger than fixed-income ETFs. Taxable bond mutual funds have more than four times the assets under management as taxable bond ETFs (see chart 8).
As in mutual funds, most corporate and broad market fixed-income ETFs have an investment-grade focus. While high yield and leveraged loan ETFs have gained in popularity as an easy avenue for investors to gain access to these markets, only about 18% of corporate bond ETFs are primarily focused on high yield. Assets under management of high-yield bond ETFs stands at $58 billion, while the assets under management (AUM) of investment-grade corporate ETFs stands at $266 billion at the beginning of the year, according to Refinitiv Lipper (see chart 9).
How Does S&P Global Ratings Assess The Potential Credit Quality Of Fixed-Income ETFs?
S&P Global Ratings has rated fixed-income ETFs since 2002. We employ a multifactor approach to assign a fund credit quality rating (FCQR) that includes both a quantitative assessment of the credit quality of the portfolio holdings and a qualitative assessment of the fund sponsors' resources and capabilities. The goal of our analysis is to uncover sources of risk in a fund's portfolio and investment strategies, and to assess the potential impact on its ability to meets its objectives.
Our outstanding ETF ratings include 37 U.S.-focused, corporate bond ETFs with nearly $130 billion in assets under management (as of Dec. 31, 2019). Most have an FCQR in the 'BBB f' category or higher. Ten had an FCQR of 'BBf' or lower. High-yield-focused ETFs tend to display weaker portfolio metrics, reflecting their concentration in riskier credit. The FCQR scale ranges from 'AAAf' to 'Df'.
For more information on our methodology to assess fixed income ETFs, please see "Fund Credit Quality Ratings Methodology" (published June 26, 2017) to assess fixed-income ETFs.
Do ETFs Face The Same Kind Of Short-Term Outflow Risk Mutual Funds Did In March?
While ETFs are subject to short-term outflows, the mechanism for these inflows and outflows is different from that of mutual funds.
Unlike open-ended mutual funds, ETF investors cannot simply redeem their investment from the ETF manager; instead they sell their ETF shares to a buyer on an exchange. Only a small number of authorized participants in an ETF are able to redeem ETF shares directly from the manager. In a "redemption," the ETF delivers as a representative basket of the funds' assets in exchange for a number shares of the ETF, rather than a cash settlement.
The opposite of this redemption mechanism is the creation mechanism, where authorized participants can exchange a basket of the underlying securities for newly created shares in the ETF.
These mechanisms give authorized participants an arbitrage opportunity whenever the net asset value of the ETF drifts away from the price of the shares, and this generally functions to keep ETFs trading at a value very close to their NAV.
This report does not constitute a rating action.
|Primary Credit Analyst:||Evan M Gunter, New York (1) 212-438-6412;|
|Secondary Contact:||Andrew Paranthoiene, London (44) 20-7176-8416;|
|Head of Ratings Performance Analytics:||Nick W Kraemer, FRM, New York (1) 212-438-1698;|
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