As fixed income markets go, the Canadian market is relatively small. Canadian government bonds comprise less than 3% of overall issuance from G7 countries, while Canadian corporate bonds account for less than 1% of the global market. Yet, size has not prevented this market from leading the world in at least one important way: the rapid adoption by institutional investors of fixed income exchange traded funds (ETFs).

According to a recent survey conducted by Greenwich Associates and sponsored by BlackRock Canada, nearly 70% of Canadian institutional investors now employ fixed income ETFs, significantly higher than in the United States or Europe. Almost as remarkable is the speed at which this trend is growing. According to the survey, more than half of institutions used bond ETFs a year ago; two years ago, fewer than 50% did.

Read: ETF industry made gains in January

To understand the phenomenon, one has to look closely not just at the quantum of ETF use, but also at the specifics of how institutions are using the funds. Here is a shortlist of the most important ways:

1. Tactical adjustments

Fixed income ETFs provide immediate market exposure – something that can be highly valuable to institutions that want to quickly build positions for tactical reasons. In the traditional, opaque over-the-counter bond market, investors can face significant challenges in sourcing and accumulating positions in individual issues in a timely and cost-efficient manner. ETFs make this kind of adjustment far easier. They provide efficient access to a broadly diversified basket of bonds, and they do it right away.

Read: How institutional investors use ETFs

For example, one of the most valuable – and often the first – applications of fixed income ETFs for institutional investors is to put large temporary cash allocations to work in the market. The cost efficiency, immediacy and secondary market liquidity of ETFs can prove highly beneficial to supporting these cash equitizations.

2. Core allocations

In a world of low yields, institutional investors are increasingly seeking cost efficiencies. Many bond ETFs that have large assets under management and robust secondary markets are far cheaper to trade than the underlying securities. For institutions, trading costs in these ETFs might be as little as a single basis point, compared with perhaps 50 bps for high-yield bonds in the traditional over-the-counter market. Especially for smaller portfolios allocations, using ETFs to achieve core positions offers not only operational efficiency and immediate diversification, but also significant cost efficiency relative to a portfolio of legacy bonds.

The variety and specialization of ETFs can also provide institutions with an immediate and cost-efficient way to adjust the risk profile of their core allocations. For instance, an investor may employ a rate-hedged ETF to adjust a portfolio’s average duration, reducing interest rate risk while maintaining credit-risk-related yield in the core.

3. Transitions

For asset managers seeking to achieve benchmark positions, ETFs can provide an efficient alternative to traditional bond sourcing via brokers/dealers, which can present significant operational challenges and price impacts. The key here is the create/redeem function for ETFs. An institution can, for instance, buy a bond ETF through cash increments, then redeem the ETF position in kind for the underlying cash bonds. The result is a diversified portfolio of bonds, achieved with little market trading, minimal price impact and high operational efficiency.

Read: ETF investors react to two-speed global economy

Institutions are also leveraging these benefits for manager transitions. For example, if a new manager decides to maintain only part of a previous manager’s (legacy) portfolio, selling the unwanted bonds into the cash market can translate into high transaction costs, not to mention a lot of work. ETFs, by contrast, can allow the new manager to maintain exposure to target asset classes while the portfolio is being reconstructed. The unwanted bonds can be matched to an optimal mix of ETFs, then delivered in-kind for units of the matching ETFs – often in a single trade.

4. Niche

As fixed income investors increasingly seek to diversify outside of their home market in search of yield, they can encounter substantial challenges in gaining exposure to niche markets. Emerging market debt, for instance, can be both difficult to source and expensive to transact. Gaining exposure to such hard-to-reach markets is, in fact, one of the biggest factors driving institutional ETF use, both in equities and fixed income.

5. Liquidity

Institutional investors have long recognized the liquidity benefit of equity ETFs, which trade on the secondary market. Today, more institutions are realizing the importance of the secondary market liquidity provided by bond ETFs, as well.

Read: ETF providers help plan sponsors get around liquidity issues

The heightened demand for liquidity has to do with the shifting landscape for the fixed income marketplace since the financial crisis. For a number of reasons, including post-crisis regulations that impact wholesale banks and bond dealers, traditional providers of liquidity in the bond market, are facing constraints in their capacity to support trades, particularly in corporate bonds. In short, it’s become harder for investors to buy and sell bonds. For institutional investors, ETFs provide a new additional source of liquidity by creating an all-to-all trading venue – that is, the equity exchange.

Beyond that general benefit, many institutions employ a position in an ETF to maintain a “liquidity sleeve,” often as a way to maintain the advantages of cash positions without the corresponding drag on performance. For instance, an institution might implement a portfolio of ETFs that mirrors its policy allocation, and then maintain this portfolio until there is a sudden cash demand or a change in market outlook. At that point, the ETF “sleeve” can be quickly peeled off.

Read: Fixed income ETF flows surge again

As this discussion illustrates, Canadian institutional investors are leading the world not just in how much, but also how they use bond ETFs. We expect the trend to continue.

Liquidity constraints in fixed income are not easing. Low yields will probably remain the norm for some time, so investors will remain focused on cost efficiencies. Meanwhile, their ever-increasing familiarity with the function and benefits of ETFs is likely to support even greater use.

It’s worth noting, as well, that those realities are not unique to the Canadian market. That’s why we expect that, over time, more and more institutional investors in other countries will follow Canada’s lead.

Read: Despite the volatility, Canadians show their love for ETFs

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Reliance upon information in this post is at the sole discretion of the reader.


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