Does Massive Inflow Into Bond ETFs Spell Bubble? – Investor's Business Daily

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While many experts might be questioning some of the high valuations in the stock market, massive flows into bond ETFs over the past couple of years have some investors worrying about a bond bubble.

XAutoplay: On | OffIndeed, since January 2016, bond mutual funds and ETFs combined have received an average of $1 billion a day in flows, according to data from INTL FCStone Financial and Bloomberg. Compare this with equity ETFs, which have gathered $177 billion since the election and just $99 billion the prior year.

In addition, flows into equity ETFs were mostly offset by flows out of equity mutual funds, while in the bond space, both ETFs and mutual funds benefited from higher flows.

So, how can we explain the data — and is there cause for concern?

Despite the extended period of low interest rates that the U.S. economy has experienced in the last decade or so, demand for bonds has grown tremendously as baby boomers have reached retirement age and thus have shifted their portfolios from more risky allocations such as equities into income-generating fixed income.

“There’s the demographic reason: The most wealth is concentrated with the boomer generation, and these people need more fixed-income assets as they age,” said Vincent Deluard, global macro strategist at INTL FCStone Financial. “Back in the 1990s, it was not uncommon for 40- to 50-year-olds to have almost all their wealth in equities. And then they got badly burned by the internet bubble and the 2008 crisis, and as they’re aging they have to rotate actively into bond funds.”

However, looking at flows does not indicate whether there is any type of bubble, says Matt Bartolini, head of SPDR Americas Research at State Street Global Advisors. “There’s roughly $560 billion of ETF AUM (assets under management) dedicated to just fixed income. Based on the Bank for International Settlements, the fixed-income market is over $100 trillion. So that (bond ETFs) represents less than 1% of the entire fixed-income market. I would hardly think that would ever be called some form of a bubble.”

Adding in $3.7 trillion in bond mutual funds, total fixed-income assets invested in funds and ETFs would still equal barely 4% of the entire bond market, so even here, there’s no indication of a bubble, says Bartolini.

“We’ve seen steady adoption of fixed-income ETFs, at an about 20% annual growth rate globally over the past five years,” said Steve Laipply, managing director and head of U.S. iShares’ fixed-income strategy. He says that both retail investors and larger institutional investors are finding a lot of utility in ETFs.

“A large part of the story is that investors have discovered that fixed-income ETFs are a very efficient, cost-effective way to access the bond market,” he said. “Initially it was an individual-investor story as it’s very difficult for individuals to source bonds in a scalable way, and ETFs allowed them to do that.”

Also, in times of stress, the ETF market can actually provide an incremental source of liquidity, Laipply says. A case in point is the $18 billion iShares iBoxx $ High Yield Corporate Bond ETF (HYG). “During December of 2015, the amount of volume transacted on the exchange was in excess of 20 times the amount of volume that ultimately hit the bond market in terms of redemptions,” he said.

So the way to look at fixed-income ETFs “is, rather than be limited to just the bond market, you have an additional valve — the exchange — which also provides a venue for trading to occur. So instead of being limited to one option for the flows, you now have two, so it’s incremental,” said Laipply. “So in any market, you can see stress scenarios where trading may diminish, but with a fixed-income ETF you now have two (markets) instead of one.”

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