Title: The Changing Landscape of Fund Investing: The Rise of Fixed Income ETFs and Private Credit
Introduction:
Fund investing is undergoing a transformation with the growing popularity of fixed income ETFs and the emergence of private credit as an alternative asset class. In this article, we will explore the implications of these developments, including the decline in liquidity risk premium and its impact on the high-yield bond market. We will also delve into the rise of private credit as a viable option for investors seeking attractive yields amidst global market volatility.
1. The Rise of Fixed Income ETFs: Overcoming Liquidity Challenges
1.1. Easing Portfolio Management and Reducing Trading Costs
1.2. Increased Liquidity and Lower Returns
1.3. Liquidity Risk Premium and its Impact on the High-Yield Bond Market
1.4. Disruption in the Positive Value Relationship: Bonds with Medium Liquidity Yielding Similar Returns as Bonds with Low Liquidity
2. Implications for Different Types of Investors
2.1. Active Managers and HY Mutual Funds: Benefiting from Lower Transaction Costs
2.2. Asset Allocators: Challenges Faced by Insurers and Pension Funds
2.3. Shift Towards Private Credit: A Viable Alternative for Investors
2.4. The Impact of Yield Erosion on the Private Credit Boom
3. Exploring the Private Credit Landscape
3.1. Attractive Yields and Avoiding Mark-to-Market Accounting
3.2. Structural Demand for Private Credit: Less Sensitive to Interest Rates or Macroeconomic Conditions
3.3. Increasing Allocations to Private Credit by Pension Funds and Insurers
4. The Golden Age of Private Credit
4.1. Reasons Behind the Surge in Private Credit Demand
4.2. The Role of Yield Erosion in Fueling the Private Credit Boom
4.3. Pension Fund CIOs Advocating Increased Private Capital Allocations
Expanding on the Topic: Insights and Perspectives
– Exploring the dynamics of fixed income ETFs and their impact on the broader bond market
– Analyzing the potential risks associated with the decline in liquidity risk premium and its implications for investors
– Case studies of successful private credit investments and their performance compared to traditional fixed income assets
– Examining factors influencing private credit demand, including regulatory changes and market conditions
– Evaluating the suitability of private credit as a long-term investment strategy for different types of investors
Conclusion:
The rise of fixed income ETFs and the increasing popularity of private credit are transforming the fund investing landscape. While fixed income ETFs have provided investors with enhanced portfolio management capabilities and reduced trading costs, they have also led to a decline in liquidity risk premium and lower returns in the high-yield bond market. This erosion in returns has fueled the demand for private credit, offering attractive yields and stability across economic cycles. As investors navigate these evolving investment options, it becomes crucial to understand the changing dynamics and assess the suitability of these strategies based on specific goals and risk tolerance.
Summary:
The growing interest in fixed income ETFs and private credit has reshaped the fund investing landscape. Fixed income ETFs have revolutionized portfolio management, reducing trading costs and increasing liquidity. This has resulted in a decline in the liquidity risk premium, leading to lower returns in the high-yield bond market. As a result, investors have turned to private credit as an alternative asset class, seeking higher yields and stability. The surge in private credit demand is driven by both the attractive returns and a desire to avoid mark-to-market accounting. Pension funds and insurers have increased their allocations to private credit, recognizing its merits as a source of extra returns. While the decline in yield erodes the appeal of traditional high-yield bonds, it fuels the private credit boom at the fringes. The changing investment landscape provides various distributional implications for different types of investors, including active managers and asset allocators. Overall, the fund investing industry continues to evolve, offering investors a range of options to suit their specific needs and strategies.
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Many people visceral hatred the idea of fixed income ETFs, but despite the recent volatility in the bond markets, ETFs continue to move forward, grow and altering nature of the underlying market.
The growing popularity of corporate bond ETFs and the portfolio trading which help enable – makes it easier for investors to manage portfolios, reduces trading costs and increases liquidityaccording to a new Barclays report.
This has important implications. Barclays says ETFs have dramatically lowered the “liquidity risk premium” – the extra returns investors demand to compensate for owning less liquid stocks – and led to lower returns. through the whole market for US junk bonds.
From the report, written by research lead Jeff Meli, with emphasis from Alphaville:
— New products and protocols in the high yield (HY) corporate bond market — ETFs and portfolio trading, in particular — have improved investors’ ability to manage their trading needs at a lower cost.
— A consequence of this improvement is that the HY liquidity risk premium (LRP) has declined since 2019, both relative to other asset classes and within the HY market itself. This decline has coincided with both the increased use of ETFs and the advent of portfolio trading. We estimate the yield on HY debt to be 50-100 basis points lower than it would have been in the absence of these improvements in cash management, after taking into account the level of interest rates, the IG credit spread and the composition of HY market rating.
— Within the HY market, the difference between the yield on the lowest and highest liquid bonds, adjusted for downgrades, interest rate and default risk, has decreased by 30-40% since 2019. We attribute this decline to the flattening of the positive value relationship between returns and illiquidity. In the past, HY corporate bond yields have risen monotonously as liquidity has declined. However, this relationship has changed recently, and bonds with medium liquidity have virtually the same yield as bonds with the worst liquidity. This suggests that the decline in LRP does not reflect the aggregate level of HY yields, but is instead linked to structural changes in the way investors source and access liquidity. Consistent with this explanation, the currently high returns of the HY market have not been seen since the 2015/2016 energy crisis, when the LRP represented 35% of the HY index return versus only 17% now.
A 100 basis point secular decline in average yields is quite dramatic. For example, that’s a lot more than you’d expect from a credit rating upgrade or downgrade a notch.
And notably, Meli also argues that the erosion of the liquidity risk premium – and the resulting decline in the return potential of the high-yield bond market in general – is likely fueling the increasingly voracious appetite for untraded securities. private credit.
From the report:
Our analysis has important distributional implications for investors depending on their liquidity demand and investment strategies. Active managers, such as HY mutual funds, which have to meet daily repayments and therefore have to trade a lot, have benefited from better ways to manage cash. Additionally, the performance of active managers is evaluated against their ability to consistently outperform their benchmark. While the reduction in benchmark returns (due to lower LRP) is not relevant to their relative performance metrics, the reduced transaction costs allow active managers the space to use their specialist knowledge to generate alpha, which in principle should attract more interest in their funds.
On the other hand, the decline in the liquidity risk premium has probably worsened the situation for asset allocators, such as insurers and pension funds. These buy-and-hold investors don’t handle day-to-day liquidity needs and are much less sensitive to the liquidity of their bond holdings than mutual funds. Thus, investing in the illiquid HY market offers an attractive, yet relatively risk-free way to generate extra returns for this type of investor.
As the benefits of investing in HY diminish, investors may have shifted portfolios towards other asset classes that offer more attractive investment opportunities, such as private credit . . . According to data from Preqin Pro, an increasing number of pension funds have added private credit as an asset class over the past three years, and the asset allocations for these (i.e., pension funds investing in private credit) have nearly doubled, from 3 .0% to 5.7%. Similarly, insurers continue to increase the share of private credit in their bond portfolios.
While the surge in private credit likely has many causes, we believe the combination of high-yield headwinds for asset allocators and a lack of viable alternatives was a major contributing factor.Furthermore, this source of private credit demand is structural and less sensitive to the level of interest rates or macroeconomic conditions and, as such, is likely to remain stable over the economic cycle.
As intriguing as the topic is, this one seems a bit of a stretch.
Yes, the growing interest in private credit has been driven by the higher (and ostensibly easier) yields on offer relative to government debt markets. But it looks more like the mad appetite for private credit it lowered its liquidity risk premium to minimal levels. Investors simply seem to be paying for the privilege of avoiding mark-to-market accounting, rather than being put off by the theory that potential junk bond returns have vanished.
However, it is possible that the large yield erosion identified by Barclays is helping to fuel the private credit boom at the fringes. And hey, that’s a good argument for pension fund CIOs when they advocate increasing their private capital allocations.
Further reading:
— The ‘golden age’ of private credit
— Bond portfolio trades are cheap. Why?
— High Yield ETF’s Influence on Underlying Bond Market Bounces
— The creeping equitization of the credit trade
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