us the bond investor s guide to etfs
DESCRIPTION
All about US ETFsTRANSCRIPT
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THE BOND INVESTORS GUIDE TO ETFs
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THE BOND INVESTORS GUIDE TO ETFs
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DIVERSIFIED BROAD MARKET
GOVERNMENT
INFLATION PROTECTED
GOVERNMENT/CREDIT
CREDIT
CORPORATE SECTORS
CORPORATE BULLET MATURITY
US HIGH YIELD
MUNICIPALS
MUNICIPAL BULLET MATURITY
MORTGAGE BACKED
FLOATING RATE
INTERNATIONAL/GLOBAL
EMERGING MARKETS USD DENOMINATED
EMERGING MARKETS LOCAL CURRENCY
INTEREST RATE HEDGED
DURATION
YIE
LD
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00 16.00 18.00 20.00
US TREASURY CURVE
INVESTMENT GRADE CREDIT CURVE
HIGH YIELD CREDIT CURVE
Source: BlackRock, as of 6/30/14. Past performance is not a guarantee of future results. For additional information regarding the indices represented in the chart, refer to the disclosures in the back of the document.
iSHARES FIXED INCOME ETFs: THE MOST COMPREHENSIVE ETF COVERAGE ACROSS THE YIELD CURVE
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Since iShares launched the first US fixed income exchange traded funds (ETFs) in 2002, ETFs have become an increasingly important part of the US and international bond markets.
Initially viewed as bond access vehicles for smaller investors, fixed income ETFs are now being used more frequently by larger, more sophisticated institutional investors.
This trend accelerated in the aftermath of the 2008 financial crisis as fixed income markets grew in complexity. Despite record bond issuance, new regulations have resulted in lower dealer inventories, thus driving down trading volumes and liquidity for individual bonds.
Meanwhile, investors have become more familiar with trading fixed income ETFs. Many fixed income ETFs have developed a robust level of on-exchange liquidity, supplementing the underlying bond market. Increasingly, institutional investors are turning to fixed income ETFs for their flexibility, liquidity, cost-effectiveness, and exchange tradability.
$131B 70
US fixedincome AUM1
Number of US fixed income ETFs1
iShares Fixed
Income ETFs
EXCHANGE TRADED FUNDSFOR THE BOND BUYER
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Despite significant growth over the last decade, the ETF market remains small when compared to the cash bond and mutual fund markets. However, we believe assets in fixed income ETFs could reach $2 trillion globally over the next decade.
As a pioneer of fixed income ETFs, BlackRock continues to drive the industrys innovation, from introducing the first corporate, Treasury, high yield, municipal, and bullet maturity ETFs in the US, to offering flagship products that have experienced tremendous growth in assets and trading volume.
As such, we have created The Bond Investors Guide to ETFs, the first dedicated resource for investors interested in using ETFs in their bond portfolios.
Matthew Tucker, CFAHEAD OF BLACKROCKS iSHARES FIXED INCOME STRATEGY
65% 39% 32%
Share of total industry trading volume1
10-yr growth rate in fixed income ETF assets2
10-yr growth rate in fixed income ETF trading volume2
1. Source: BlackRock, as of 6/30/14.2. Source: BlackRock. Compound annual growth rate as of 12/31/13.
EXE
CU
TIVE
SU
MM
AR
Y
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TABLE OF CONTENTS
INTRODUCTION 6
CHAPTER 1 BENEFITS OF iSHARES FIXED INCOME ETFs 13
CHAPTER 2 KEY ETF INVESTMENT TRENDS 27
2.1 FLEXIBLE CAPITAL MARKETS TOOLS 31
2.2 PREPARE FOR RISING RATES 57
2.3 BULLET MATURITY ETFs 75
2.4 PURSUE GLOBAL OPPORTUNITIES 93
CHAPTER 3 ETF MECHANICS 105
CHAPTER 4 TRADING AND ANALYSIS TOOLS 119
ADDITIONAL RESOURCES 130
PRODUCT GUIDE 132
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INTRODUCTION | 6
Fixed income ETFs are typically 1940 Act funds consisting of a portfolio of bonds and are traded on an exchange like an equity security. iShares Fixed Income ETFs are generally fully funded, unlevered vehicles that hold cash bonds.
Most fixed income ETFs track market indices that follow targeted segments of the markets, such as US Treasury, high yield, or emerging market bonds.
Rather than trading fixed income through the over-the-counter (OTC) bond market, investors can access these exposures on an exchange, which can lower the cost of trading and improve price transparency.
Institutional investors primarily use fixed income ETFs as core long- term investment holdings, tools for targeting precision exposures, and as financial instruments that serve as substitutes or complements to derivatives.
FIXED INCOME ETFs: THE BASICS
JULiShares launches the first fixed income ETFs in the US(LQD, SHY, IEF, TLT)
2002 2003 2004
SEP/DECiShares launches firstaggregate bond ETF (AGG) and first TIPS ETF (TIP)
DECFixed income ETF industry reaches $10B
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72005 2006 2007
JUNiShares Treasury ETF (TLT) exceeds $500M in daily trading volume
DECFixed income ETF industry reaches $25B
MARiShares first to launch agency MBS ETF (MBB)
INTR
OD
UC
TIO
N
PR
IMA
RY
USE
S
CORE INVESTMENTS
PRECISION EXPOSURES
FINANCIAL INSTRUMENTS
BO
ND
ETF
FE
ATU
RES
EXCHANGE LISTED LIKE A STOCK
DIVERSIFIED LIKE A PORTFOLIO OF BONDS
FIXED INCOME ETFs
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INTRODUCTION | 8
The US fixed income ETF market is quickly becoming an integral part of the fixed income landscape, with the liquidity crisis of 2008 serving as a catalyst.
The subsequent growth in fund size, breadth of bond market exposures, and liquidity has continued to drive increased adoption of ETFs.
A wide cross section of investors, including endowments, asset managers, insurance companies, and pension funds, are now pioneering new investment approaches using ETFs to gain fixed income exposure.
GROWTH IN FIXED INCOME ETFs HAS ACCELERATED SINCE 2008
2007 2008
SEPiShares first to launch municipal ETF(MUB)
JANTLT reaches $1B in daily trading volume
APRiShares first to launch high yield bond ETF (HYG)
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9Source: BlackRock, Bloomberg, as of 6/30/14.
2009
APR/SEPLQD reaches $10B in AUM and iShares launches first fixed income ETF in Latin America
SEPiShares ETFs are a source of liquidity in frozen markets; HYGs liquidity triples in week of Lehmans default
2010
JANiShares first to launch bullet maturity ETFs
INTR
OD
UC
TIO
N
US FIXED INCOME ETF AUM IS OVER $270B
OTHERINTERNATIONAL/EM
ACTIVEMORTGAGE
HIGH YIELD
IG CREDIT
BANK LOANS
INFLATION-LINKED
MUNICIPALS
GOVT/CREDIT
GOVERNMENT
AGGREGATE
300
250
200
150
100
50
0
2002 2003
TOTA
L AU
M ($
B)
Assets have climbed 380% since 2008 as investor adoption has increased and usage has broadened
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014YTD
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INTRODUCTION | 10
2011 2012
MOMENTUM CONTINUES TO BUILD
In 2014, independent research provider Greenwich Associates released a study titled, Institutional Investors Turning to Fixed-Income ETFs in Evolving Bond Market. The study shed light on the current and anticipated use of fixed income ETFs by institutions. Greenwich Associates surveyed 110 institutional investors including investment managers, pensions, foundations, endowments, insurance companies, and registered investment advisors (RIAs).
The study confirmed that long-term structural challenges in the bond market are driving institutional adoption of fixed income ETFs to overcome obstacles in the post financial crisis environment.
JUNiShares first to launch floating rate note ETF (FLOT)
JULUS fixed income iShares reaches $100B in AUM
FEB iShares first to launch CMBS ETF (CMBS)
Access the full Greenwich study at iShares.com/BIG
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11
2013 2014
Source: Greenwich Associates, 2014. Institutional Investors Turning to Fixed-Income ETFs in Evolving Bond Market. Based on 110 responses: 42 investment managers, 29 RIAs, 21 institutional funds, and 18 insurance companies.
KEY FINDINGS
FEBiBonds suite of bullet maturity ETFs expanded to 16 funds
OCTLQD reaches $25B in AUM
JUNHYG and LQD exceed $1B in daily trading volume
INTR
OD
UC
TIO
N
TOP REASONS FOR ETF USEAmong institutions employing ETFs, 80% cite ease of use and liquidity as top selection criteria.
GROWING USE OF ETFs AS CORE HOLDINGSNearly 50% of current users have transitioned from primarily tactical applications to more long-term strategic holdings.
CURRENT USERS INCREASING ETF EXPOSUREOf those currently employing ETFs, 32% expect to increase their allocations in the coming year.
NEW USERS INITIATING ETF POSITIONS20% of non-users plan to begin using fixed income ETFs in the next year, and 67% plan to allocate between 6-10%.
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BENEFITS OF iSHARES FIXED INCOME ETFs 1
As institutional usage of fixed income ETFs continues to grow, investors are recognizing their many benefits over traditional bonds, including trading flexibility and efficiency.
Mark Miller HEAD OF BLACKROCKS iSHARES U.S. FIXED INCOME DISTRIBUTION
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CHAPTER 1 | 14
Institutional investors are recognizing that fixed income ETFs can bring flexibility, liquidity, cost-effectiveness, and efficiency to bond investing.
BENEFITS OF iSHARES FIXED INCOME ETFs
FLEXIBILITYETFs enable a variety of broad and targeted exposures.
LIQUIDITYETFs offer an additional source of liquidity for fixed income investors.
COST-EFFECTIVENESS ETFs may provide bond investors with significant cost savings.
EFFICIENCY ETFs help overcome the challenges in the OTC market.
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15
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CHAPTER 1 | 16
ETFs enable investors to gain broad market exposure in a single trade, or create highly customized solutions by targeting specific fixed income sectors.
Investors may quickly increase or decrease exposures to target sectors more precisely and efficiently through ETFs than could otherwise be accomplished using the underlying OTC bond or derivative markets.
Conversely, some market participants may choose to express their views by short selling ETFs.1 As short selling activity increases ETF demand, long-term ETF investors may elect to engage in a securities lending program to help enhance portfolio yield.
The instantaneous diversification, targeted long and short exposures, and lending opportunities provided by fixed income ETFs add flexibility to even the most sophisticated investors.
iShares offers 70 fixed income ETFs including Treasury, corporate, high yield, international, emerging markets, floating rate note, and multi-sector exposures.
1. With short sales, an investor faces the potential for unlimited losses as the securitys price rises.
ETFs ENABLE A VARIETY OF BROAD AND TARGETED EXPOSURES
FLEXIBILITY
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17
DISAGGREGATING THE BARCLAYS AGGREGATE
Source: Barclays, BlackRock, as of 6/30/14. Holdings are subject to change. For illustrative purposes only.
Broad Exposure:Build a portfolio in a single trade with iShares Core U.S. Aggregate Bond ETF (AGG).
Targeted Exposure:Create a customized portfolio with components of the Barclays Aggregate Index. Holding components allows for tactical portfolio tilts.
AGG
CMBS 3.6%
AGZ 2.1%
ABS 0.5%
SHY 14.6%
IEI 13.2%
IEF 3.2%
TLH 0.8%
TLT 3.5%
MBB 28.9%
CRED 29.5%
BARCLAYS 1-3 YEAR TREASURY (SHY)
BARCLAYS 3-7 YEAR TREASURY (IEI)
BARCLAYS 7-10 YEAR TREASURY (IEF)
BARCLAYS 10-20 YEAR TREASURY (TLH)
BARCLAYS 20+ YEAR TREASURY (TLT)
BARCLAYS MBS (MBB)
BARCLAYS CREDIT (CRED)
BARCLAYS CMBS (CMBS)
BARCLAYS AGENCY (AGZ)
ASSET-BACKED SECURITIES
TREASURYCORPORATE
MBS
CMBS
AGENCY
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CHAPTER 1 | 18
The growth of the fixed income ETF market has helped create a new, incremental source of liquidity for investors, above and beyond what can be accessed in the OTC market. Fixed income ETFs effectively provide an additional trading venuethe exchangewhere shares can be transferred among investors without accessing the OTC market. In this way, ETFs act as an additional layer of liquidity for investors seeking bond exposure.
Through a unique set of circumstancesthe financial crisis, the US Treasury downgrade, and the tapering of quantitative easingfixed income ETF liquidity has increased relative to the OTC market. Since the beginning of 2008, trading volume has grown more than 700% as investors have turned to ETFs in times of stress.
Today, trading in fixed income ETFs averages $3.5B per day and iShares ETFs represent nearly 65% of total ETF trading volume.
ETFs OFFER AN ADDITIONAL SOURCE OF LIQUIDITY FOR FIXED INCOME INVESTORS
LIQUIDITY
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19
A SECOND LAYER OF FIXED INCOME LIQUIDITY
MO
NTH
LY T
RA
DIN
G V
OLU
ME
($B
)
There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. Source: BlackRock and Bloomberg, as of 6/30/14.
0
20
40
60
80
100
120
140
03 JUN
06 JUN
09 JUN
12 JUN
04 JUN
07 JUN
10 JUN
13 JUN
05 JUN
08 JUN
11 JUN
14 JUN
TOTAL ETF TRADING VOLUME
iSHARES ETF TOTAL VOLUME
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CHAPTER 1 | 20
iShares ETFs generally offer price improvement, making the ETF less expensive to trade than the underlying bonds of the respective index. Relative to a basket of bonds, ETFs offer the benefit of on-exchange liquidity, which often results in lower transaction costs.
As illustrated on the opposite page, the bid/offer spread of many fixed income ETFs is tighter than their underlying bond baskets.
ETFs MAY PROVIDE BOND INVESTORS WITH SIGNIFICANT COST SAVINGS
COST-EFFECTIVENESS
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21
1. Underlying basket bid/offer spread refers to the underlying securities of the respective index. 20-day average daily volume, as of 6/30/14. For illustrative purposes only. Source: BlackRock, Bloomberg, Barclays, NYSE Arca, as of 6/30/14.
iSHARES CORE U.S.
AGGREGATE BOND ETF
iSHARES J.P. MORGAN
USD EMERGING MARKETS BOND ETF
iSHARES IBOXX $
HIGH YIELD CORPORATE
BOND ETF
iSHARES IBOXX $
INVESTMENT GRADE
CORPORATE BOND ETF
iSHARES 10+ YEAR
CREDIT BOND ETF
iSHARES INTERMEDIATE
CREDIT BOND ETF
iSHARES 1-3 YEAR CREDIT
BOND ETF
iSHARES NATIONAL AMT-FREE
MUNI BOND ETF
iSHARES TIPS
BOND ETF
iSHARES 20+ YEAR
TREASURY BOND ETF
iSHARES 1-3 YEAR
TREASURY BOND ETF
106 55 876 61 19 127 28 7 112 252 112
17,600 7,931 3,788 13,181 3,316 11,870 5,877 500 17,804 13,727 5,191
iSHARES ADV ($M)
iSHARES AUM ($M)
BID
/OFF
ER
SP
RE
AD (B
PS
)
iSHARES ETF BID/OFFER
UNDERLYING BASKET BID/OFFER1 (EST.)
AGG SHY TLT TIP MUB CSJ CIU CLY LQD HYG EMB
15
1 1 1 1 1 1 22
15 15 1512 11
50
25
40
78
25 5 4
0
10
20
30
40
50
60
70
80
ETFs MAY OFFER THE POTENTIAL FOR PRICE IMPROVEMENT
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CHAPTER 1 | 22
Much of the cost savings that fixed income ETFs offer arise from the fact they trade on an exchange. This allows for efficient trading, which alleviates many of the impediments caused by dislocations in the OTC market.
The OTC market creates a number of challenges for an investor. First, it is difficult to determine best execution. An investor can solicit market bids or offers from a selection of dealers, but that investor has no way of knowing whether they executed at the best available price in the market.
Second, OTC markets generally provide either the bid or offer price for a transaction, making it difficult to directly observe trading spreads.
Finally, issues can be difficult to find as lower dealer inventories and the fragmented structure of the OTC bond market make sourcing bonds operationally intensive.
ETFs HELP OVERCOME THE CHALLENGES IN THE OTC MARKET
EFFICIENCY
-
23
In contrast to bonds, fixed income ETFs are traded on a centralized exchange such as the NYSE. Through the exchange, investors can easily see execution prices throughout the trading day. Unlike the OTC bond market, the exchange provides a high level of visibility into trading volumes, two-sided market levels (both bid and offer), and transaction costs. It also offers investors more control over trade execution by allowing them to execute limit, stop loss, and short orders.
Fixed income ETFs bring efficiency and transparency to bond trading, allowing investors to transact bonds as easily as listed equity securities.
OTC MARKETS(FRAGMENTED MARKETPLACE)
EXCHANGE MARKETS(CENTRALIZED MARKETPLACE)
EXCHANGE BROKER INVESTOR
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CHAPTER 1 | 24
Due to their numerous benefitsflexibility, liquidity, cost-effectiveness, and trading efficiencyinvestors are employing iShares Fixed Income ETFs in innovative ways to achieve both long-term strategic and short-term tactical objectives.
CORE EXPOSURE
STRATEGY
APPLICATIONS OF FIXED INCOME ETFs
1. Source: Greenwich Associates 2014 U.S. Fixed-Income ETF Study. Investor usage defined as percent of investors who employed the strategy with an ETF in the past two years. Based on 59 responses: 21 investment managers, 21 RIAs, 9 insurance companies, and 8 institutional funds.Institutional funds are defined as pensions, foundations, and endowments.
TACTICAL ADJUSTMENTS
PORTFOLIO COMPLETION
REBALANCING
INTERIM BETA
TRANSITIONS
ETF OVERLAY/LIQUIDITY SLEEVE
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25
OBJECTIVE INVESTOR USAGE1
0% 20% 40% 60% 80%
INSTITUTIONAL FUNDS INSURERS RIAs INVESTMENT MANAGERS
Long-term exposure as part of a strategic asset allocation
Over- or under-weight certain exposures based on short-term views or market conditions
Minimize benchmark risk while maintaining portfolio objectives
Manage portfolio risk between rebalancing cycles
Maintain beta exposure while searching for a manager
Efficiently transition portfolio holdings with an in-kind exchange
Improve liquidity of a portfolio while maintaining strategic asset allocation
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2The most innovative changes in the ETF industry arise not from product providers, but from clients who are finding new ways that ETFs can improve investment results.
Daniel Gamba, CFA HEAD OF BLACKROCKS iSHARES AMERICAS INSTITUTIONAL BUSINESS
KEY ETF INVESTMENT TRENDS
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CHAPTER 2 | 28
Institutions are making sizeable portfolio allocation shifts and are looking for new exposures to express their investment views.
Consequently, The Bond Investors Guide to ETFs focuses on four major ETF investment trends. To illustrate these themes, the book is constructed to highlight relevant ETF research and insights, spotlight specific ETF solutions, and reveal how institutions are employing ETFs through a series of case studies.
KEY ETF INVESTMENT TRENDS
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29
FLEXIBLE CAPITAL MARKETS TOOLSLiquid fixed income vehicles to efficiently gain market exposure
PREPARE FOR RISING RATESETF strategies to manage duration in a rising interest rate cycle
BULLET MATURITY ETFsETFs designed to mature like a bond, trade like a stock, and that are diversified like a fund
PURSUE GLOBAL OPPORTUNITIESSeek yield and diversify domestic bond portfolios with ETFs
1
2
3
4
-
KEY ETF INVESTMENT TRENDS:
FLEXIBLE CAPITAL MARKETS TOOLS 2.1
ETFs present an incredibly efficient way to buy and sell market beta, allowing us to put risk on or off and manage our cash positions.
James Keenan, CFA PORTFOLIO MANAGER AND HEAD OF BLACKROCK AMERICAS CREDIT
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CHAPTER 2.1 | 32
Investors face a number of liquidity challenges in the corporate bond market. Liquidity, measured by both trading volumes and average trade size, has been declining since 2007.
At the same time, the 2008 financial crisis and subsequent reforms led to a reduction in the amount of capital that banks, brokers, and other traditional liquidity providers commit to supporting secondary bond trading. This further reduced the tradable supply of bonds, impacting investors efforts to source and get bids on specific issues.
In addition, the OTC corporate bond market has experienced rising fragmentation of issuance, whereby dozens or even hundreds of unique securities are issued by the same entity. This fragmentation dilutes security-level liquidity as investors are forced to grapple with a myriad of bonds from a given issuer with different coupon levels, seniority, call features, and maturity dates.
As a result, corporate bonds face discontinuous liquidity, where some individual securities trade infrequently, or not at all, during a given month. In 2013, 37% of the 37,000+ TRACE eligible bonds did not trade once, which made it difficult for investors to liquidate or purchase securities.
The net impact of these recent challenges has resulted in the rapid increase in fixed income ETF assets.
INTRODUCTION:
A NEED FOR SOLUTIONS AS BOND MARKET LIQUIDITY HAS DECLINED
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33
DEALER BOND INVENTORIES HAVE BEEN DECLINING SINCE 2007
Source: BlackRock, Bloomberg, as of 3/31/13. Primary dealer inventory is measured by the primary dealer positions outright level of corporate securities due greater than one year. Credit ETF assets include US listed corporate and credit bond ETFs, excluding leveraged or inverse funds, bank loan funds, floating rate funds, and convertible funds.
ASS
ETS
($B
)
SE
P0
2
JU
N1
2
SE
P0
7
JU
N1
1
SE
P0
6
JU
N1
0
SE
P0
5
JU
N0
9
SE
P0
4
JU
N0
8
SE
P0
3
DE
C0
2
SE
P1
2
DE
C0
7
SE
P1
1
DE
C0
6
SE
P1
0
DE
C0
5
SE
P0
9
DE
C0
4
SE
P0
8
DE
C0
3
MA
R0
3
DE
C1
2
MA
R0
8
DE
C1
1
MA
R0
7
DE
C1
0
MA
R0
6
DE
C0
9
MA
R0
5
DE
C0
8
MA
R0
4
JU
N0
3
MA
R1
3
MA
R1
2
JU
N0
7
MA
R1
1
JU
N0
6
MA
R1
0
JU
N0
5
MA
R0
9
JU
N0
4
Credit ETFs help bridge the liquidity gap created by lower dealer inventories
PRIMARY DEALER POSITIONS CREDIT ETF ASSETS
0
50
100
150
200
250
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CHAPTER 2.1 | 34
ETFs have proven to be effective fixed income exposure vehicles. iShares offers some of the largest and most liquid fixed income ETFs available. These ETFs are ideal for institutional investors requiring flexible capital markets tools in less liquid bond markets. Many iShares Fixed Income ETFs have sufficiently long track records, assets, and liquidity to be used for institutional trading purposes.
BROADAGG iShares Core U.S. Aggregate Bond ETF
TREASURIESTIP iShares TIPS Bond ETFSHV iShares Short Treasury Bond ETFSHY iShares 1-3 Year Treasury Bond ETFIEI iShares 3-7 Year Treasury Bond ETFIEF iShares 7-10 Year Treasury Bond ETFTLT iShares 20+ Year Treasury Bond ETF
CREDITLQD iShares iBoxx $ Investment Grade Corporate Bond ETFHYG iShares iBoxx $ High Yield Corporate Bond ETFCSJ iShares 1-3 Year Credit Bond ETFCIU iShares Intermediate Credit Bond ETF
SPECIALTYMBB iShares MBS ETFFLOT iShares Floating Rate Bond ETFMUB iShares National AMT-Free Muni Bond ETFEMB iShares J.P. Morgan USD Emerging Markets Bond ETF
ETF SPOTLIGHT:
iSHARES ETFs AS CAPITAL MARKETS TOOLS
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35
SPEAKING VOLUMES: iSHARES OFFERS SOME OF THE MOST LIQUID ETFs IN THE MARKET
Source: BlackRock, as of 6/30/14. 1. DV01, also known as dollar value 01 or basis point value, represents the change in dollar value of a fund investment given a 1 basis point move in interest rates. The figure is derived from a funds effective duration and assumes a $1M investment.
AGG TIP SHV SHY IEI IEF TLT LQD HYG CSJ CIU MBB FLOT MUB EMB
106 61 31 55 28 272 876 112 252 127 28 44 22 19 112
471 873 1,255 4,604 5,208 1,553 4,988 1,273 1,494 1,159 302 446 459 150 526
11 11 7 12 7 12 12 12 7 7 7 7 3 7 7
518 769 39 189 456 762 1,687 779 391 192 424 410 14 613 710
20-DAY ADV ($M)
HIST. MAX ADV ($M)
TRACK RECORD
(YRS)
DV01 ($)1
20-DAY ADV ($M)
HISTORICAL MAX ADV ($M)
MAX
AVE
RAG
E D
AILY
VO
LUM
E ($
M)
20-DAY AVE
RAG
E D
AILY VOLU
ME
($M)
AGGTIP
SHV
SHYIEI
IEFTLT
LQD
HYG
CSJCIU
FLOTMBB
MUB
EMB
5000
800
4000
600
3000
400
2000
1000
200
0
0
-
CHAPTER 2.1 | 36
As fund liquidity increases, large trades are becoming more frequent. Using iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) and iShares iBoxx $ High Yield Corporate Bond ETF (HYG) as proxies for investment grade and high yield corporate credit, there is evidence of an uptick in the frequency of large institutional tradesdefined as single trades greater than $10Mas a portion of total ETF trading activity.
In 2009, large trades accounted for 10% of LQDs and 8% of HYGs total trading volume. Trades of this size have steadily climbed to over 20% of trading activity for both LQD and HYG.
INSIGHT:
GROWING TRADE SIZES IN CREDIT ETFs
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37
Source: BlackRock, Bloomberg, as of 12/31/13. Graph shows the total value of single trades over $10M as a percentage of total dollar trading volume for the previous three months.
HIGHER FREQUENCY OF LARGE ETF TRADES
LAR
GE
TR
ADE
VAL
UE
AS
% O
F AL
L TR
ADES
0
5
10
15
20
25
30
35
MA
R0
9
MA
R1
0
MA
R1
1
MA
R1
2
MA
R1
3
JU
N0
9
JU
N1
0
JU
N1
1
JU
N1
2
JU
N1
3
SE
P0
9
SE
P1
0
SE
P1
1
SE
P1
2
SE
P1
3
DE
C0
9
DE
C1
0
DE
C1
1
DE
C1
2
DE
C1
3
INVESTMENT GRADE (LQD) HIGH YIELD (HYG)
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CHAPTER 2.1 | 38
Fixed income ETFs offer an important additional layer of liquidity that may reduce total transaction costs. In many cases, ETF purchases can be satisfied by existing ETF market liquidity on the exchange.
Large institutional trades exceeding the exchange liquidity result in the creation of new ETF shares to complete the remainder of an order.
$100M HIGH YIELD ETF TRADE
$100M BUY
$100M trade is executed accessing the liquidity of the available ETF shares
ETF LIQUIDITY (ADV: $252M)
INSIGHT:
TRADES OF ALL SIZES CAN BENEFIT FROM ETF LIQUIDITY
$252M of the trade is executed through the liquidity of available ETF shares
ETF LIQUIDITY (ADV: $252M)
$300M HIGH YIELD ETF TRADE
$300M BUY
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39
OTC MARKET LIQUIDITY (ADV: $7.1B)
$48M of the trade is executed through creating new ETF shares using the OTC market
Source: Bloomberg, Barclays Capital TRACE, NYSE Arca, BlackRock. ETF liquidity represented by 20-day average daily volume data as of 6/30/14 for the iShares iBoxx $ High Yield Corporate Bond ETF. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. Example is for illustrative purposes only.
100% of the trade benefits from transaction savings of available ETF liquidity
Over 80% of the trade benefits from transaction savings of available ETF liquidity
The remainder of the trade is filled at prevailing OTC market costs
The total weighted average cost of the trade would be lower than sourcing exclusively from the OTC market
OTC MARKET LIQUIDITY (ADV: $7.1B)
OTC market is not accessed
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CHAPTER 2.1 | 40
During periods of increased market volatility, OTC bond market liquidity generally declines as trading becomes concentrated in a subset of larger and more liquid issues, and investors encounter difficulty transacting in less liquid securities.
A recent example occurred between May and July 2013 when the Federal Reserve hinted at a plan to taper quantitative easing measures. This resulted in large outflows and significant volatility across fixed income markets, particularly in the high yield sector.
Interestingly, most of the outflows that occurred during the period were through traditional pooled vehicles rather than ETFs. In fact, exchange liquidity increased dramatically for iShares iBoxx $ High Yield Corporate Bond ETF (HYG). HYG breached the $1B in trading volume threshold five times during this period, allowing investors to meet and trade high yield exposure without tapping the OTC market. In fact, most of the trading occurred on the exchange, roughly ten shares traded for every one that was redeemed. The ETFs ability to absorb the spike in volume highlights the value the additional layer of liquidity that credit ETFs can provide during a period of market volatility.
The behavior of HYG during bouts of market stress serves as evidence that ETFseven in less liquid markets can be a robust vehicle for managing and transferring risk. It is because of these exchange liquidity attributes that liquid fixed income ETFs, such as HYG, have become key indicators of cash bond market movements.
FIXED INCOME ETFs AND THE CORPORATE BOND LIQUIDITY CHALLENGEFixed Income ETFs and the
Corporate Bond Liquidity Challenge Access the full whitepaper at iShares.com/BIG
INSIGHT:
HIGH YIELD ETFs IN STRESSED MARKETS
-
41
Source: BlackRock, Bloomberg, as of 12/31/13. Rolling 20-day average shown for each. Cash bonds are measured by FINRA TRACE Market Breadth High Yield and High Grade Bond Dollar Indexes and ETF volume is ADV. The case study references 5/29/13. Case studies are for illustrative purposes only; they are not meant as a guarantee of any future results of experience. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.
HYG DOLLAR VOLUME AS A PERCENT OF HIGH YIELD CASH BONDS
TAPERING FEARS: HYG EXCHANGE VOLUME VERSUS CREATION/REDEMPTION ACTIVITY
IN TIMES OF STRESS, ETFs PROVIDE ACCESS TO ILLIQUID MARKETS
HYG
VO
LUM
E/C
ASH
BO
ND
VO
LUM
E (%
)E
XCH
ANG
E V
OLU
ME
TO
CR
EAT
E/R
ED
EE
M R
ATIO
(2
0-D
AY R
OLL
ING
)
Trading volumes increased sharply as investors utilized the liquidity of the ETF
2008 CRISIS
TREASURY DOWNGRADE
0
2
4
6
8
10
12
14D
EC
08
DE
C0
9
DE
C1
1
DE
C1
0
DE
C1
2
MA
R0
8
DE
C0
7
MA
R0
9
MA
R1
0
MA
R1
2
MA
R1
1
MA
R1
3
JU
N0
8
JU
N0
9
JU
N1
0
JU
N1
2
JU
N1
1
JU
N1
3
DE
C1
3
SE
P0
8
SE
P0
9
SE
P1
0
SE
P1
2
SE
P1
1
SE
P1
3
TAPERING FEARS
On average, 10 shares of HYG were traded on the exchange for every one share that was redeemed
0
5
10
15
20
25
30
13 JAN
13 FEB
13 MAR
13 APR
13 MAY
13 JUN
13 JUL
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CHAPTER 2.1 | 42
Investors may gain credit exposure through a variety of means, including cash bonds, credit default swaps (CDS/CDX), total return swaps (TRS), and ETFs.
Institutional investors who receive large inflows of cash are faced with access, liquidity, and timing issues related to their investments. Delays in full allocation can create yield drag and tracking error. Alternatively, institutions may need to hedge credit positions as they attempt to shift allocations or alter risk profiles.
Each of these credit access vehicles offers unique attributes, giving investors choice and flexibility in their investment approach.
An investors preference for one approach over another is a function of the following considerations:
Desire for cash or synthetic exposure Preference of interest rate vs. credit spread composition Leverage and liquidity requirements Direction (long vs. short) Holding period Operational, accounting, and regulatory considerations Relative cost of each vehicle
INSIGHT:
EXPLORING CREDIT ACCESS VEHICLES
-
43
Exchange traded bond portfolios are generally designed to track specified indices
Increasing rates of adoption and liquidity
EXCHANGETRADED FUNDS
(ETFs)
Derivative contracts designed to target credit spreads
Most liquid and actively traded credit products
Significant differences in performance vs. cash bonds can arise for sustained periods of time
CREDIT DEFAULTSWAPS
(CDS/CDX)
OTC swap products designed to pay the total return on specified credit indices
Generally lower levels of liquidity and higher transaction costs (strike premiums and bid/offer spreads) relative to CDX and ETFs
TOTAL RETURN SWAPS
(TRS)
-
CHAPTER 2.1 | 44
TOTAL RETURN SWAPS AND CREDIT ETFs
Credit ETFs and total return swaps TRS on Markit iBoxx indices are both used by investors who are seeking to obtain long or short exposure to the investment grade or high yield credit markets.
Credit ETFs are portfolios of bonds that trade on exchange and track a specified benchmark, while iBoxx TRS are synthetic, unfunded derivative index products. An investors preference for one product over the other will be a function of desired leverage, the direction of the exposure (long vs. short), holding period, on-demand liquidity requirements, operational constraints, and the relative cost and attractiveness of each vehicle in given market conditions.
Investors who do not require leverage should evaluate the relative cost and liquidity of credit ETFs and TRS. Larger credit ETFs with longer track records may offer ample exchange liquidity, while TRS liquidity varies depending on participating counterparties and risk appetites. Market impact for larger trades in more liquid credit ETFs can be 10 bps or less, whereas TRS quoted bid/offer spreads are typically between 40-50 bps at initiation.
TRS are OTC bilateral contracts, which expose investors to the credit risk of the dealer counterparty, though this risk may be managed through the use of margin/collateral requirements. As ETFs are exchange traded, counterparty risk is negligible and there are no collateral requirements.
The historical performance of ETFs and TRS has been similar through time for both long and short market exposures.
INSIGHT:
COMPARING CREDIT ETFs, TOTAL RETURN SWAPS, AND CREDIT DEFAULT SWAPS
-
45
CREDIT DEFAULT SWAPS AND CREDIT ETFs
Credit default swaps (CDX) are unfunded derivative index products that allow investors to access levered investment grade and high yield credit spreads across standardized tenors. CDX contracts are highly liquid but trade at a basis to cash bonds and do not provide exposure to interest rates.
CDX contracts provide investors with the ability to get long or short exposure to credit spreads synthetically. The standardization and fungibility of CDX contracts have led them to become the most liquid credit exposure vehicles in the market.
Alternatively, credit ETFs provide a means to attain bond exposure in a fully-funded, exchange traded format. The liquidity of credit ETFs has grown as a result of exchange transparency and tight execution cost relative to the underlying OTC market. While not as liquid as CDX, credit ETFs are typically more liquid than individual cash bonds.
An investors vehicle preference is a function of leverage and liquidity requirements, preferred composition of interest rate vs. credit spread exposure, position direction, and operational, accounting, and regulatory considerations. Investors that can trade derivatives may prefer the leverage provided by CDX. Conversely, investors who employ fully funded strategies may prefer ETFs.
Performance differences (adjusted for interest rate exposure) between credit ETFs and CDX are often driven by changes in the basis between the cash and synthetic credit markets.
Comparing Credit ETFs and Credit Default Swap Indices
Comparing Credit ETFs and Credit Index Total Return Swaps
Access the full whitepapers at iShares.com/BIG
-
CHAPTER 2.1 | 46
CREDIT ETFs
ETFs hold a basket of cash bonds designed to track a reference index and trade on an exchange
Reference index and ETFs typically rebalance monthly no investor action required
Investor may go long or short an ETF ETFs pay out income earned by fund in
periodic distributions
Liquid, inexpensive execution to gain diversified cash bond exposure
Exchange traded
No documentation requirements
Exchange
No collateral requirements
Fully funded
Bid/offer spread, commissions, expense ratio
LQD ADV1: $112MHYG ADV1: $252M ETFs can access liquidity of underlying
Yes
Yes
Monthly
LQD: > 1,200HYG: > 900
No
Yes
Large trades may need to be tactically managed and may have market impact
Expense ratio and equity commissions may add to total costs
MECHANICS
INTEREST RATE EXPOSURE
CASH/CDS BASIS
HOLDINGS
INDEX REBALANCING
ABILITY TO LEND
ABILITY TO TRADE OPTIONS
LIQUIDITY
TRANSACTION COSTS
FUNDING/LEVERAGE
COLLATERAL
OPERATIONAL RISK
DOCUMENTATION
COUNTERPARTY RISK
BENEFITS
CONSIDERATIONS
-
47
INDEX TOTAL RETURN SWAPS
Dealer counterparty pays/receives total return of index on specified notional value
Investor receives/pays LIBOR x notional value over specified term
Swap must be rolled by investor periodically to maintain exposure
Total return based on an initial index strike vs. final index level
CDX
Diversified cash bond exposure; leverage Liquid basket of CDS exposures
Bilateral counterparty risk Exchange cleared
International Swaps and Derivatives Association (ISDA), Credit Support Annex (CSA), and trade confirmations
Cleared Derivatives Execution Agreements (CDEA)
Payments, settlements, documentation Exchange cleared
Collateral requirements Exchange collateral requirements
Synthetic/unfunded Synthetic/unfunded
Index strike vs. actual index level, bid/offer spread Bid/offer spread, roll costs
Data not reported IG: $5.8BHY: $2.2B
No Yes
No No
Monthly Semi-annually
IG: > 3,900HY: > 900
IG: 125HY: 100
No Yes
Yes No
Higher transaction costs Contracts must be rolled Inconsistent liquidity
Can have sustained periods of significant tracking error vs. bonds
Contracts must be rolled
Consists of reference basket of equally weighted single-name CDS (100 for HY; 125 for IG)
Dealer counterparty pays/receives quarterly premium on specified notional vs. contingent payments based on specified credit events
Investor may go long or short
Source: Blackrock, Bloomberg, JPMorgan. 1. 20-Day ADV as of 6/30/14.
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CHAPTER 2.1 | 48
A high yield asset manager generated a 5-year cumulative return that slightly underperformed the strategy benchmark. After analyzing the portfolios performance, the manager found the 5% cash allocation had resulted in a cumulative 6% drag on performance.
The analysis showed that the manager could have significantly reduced the impact of cash drag by allocating 3% to iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and only 2% to cash. The solution would have reduced cash drag during the prior 5-year period to 2.9%, inclusive of transaction costs. This would have made the difference between outperforming and underperforming the strategy benchmark.
Given the managers need to meet cash flows, liquidity was a key consideration when selecting an ETF. With an ADV of approximately $250M, HYG acts as a liquidity tool in a sector of the market that can suffer from low trading volumes.
By holding HYG, the manager will lower the impact of cash drag while maintaining flexibility for cash flow needs.
CASE STUDY:
MINIMIZE CASH DRAG WITH FIXED INCOME ETFs
-
49
REDUCE THE EFFECT OF CASH DRAG WITH AN ETF
Sources: Morningstar, BlackRock, as of 6/30/14. For illustrative purposes only. Not indicative of any actual portfolio or asset allocation model. Portfolio with 5% Cash assumes allocation of 95% to BAML High Yield Master II Index and 5% invested in a money market fund, rebalanced monthly. No additional transaction costs are assumed. Portfolio with 2% Cash & 3% ETF assumes allocation of 95% to BAML High Yield Master II Index, 2% invested in a money market fund, and 3% invested in Markit iBoxx USD Liquid High Yield Index, rebalanced monthly, and assumes 2 bps of round-trip transaction costs for the Markit iBoxx USD Liquid High Yield Index investment per month.
Past performance does not guarantee future results. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. Case studies are for illustrative purposes only; they are not meant as a guarantee of any future results or experience.
Index returns are for illustrative purposes only and do not represent actual iShares Fund performance. Index performance returns do not reflect any management fees, transaction costs, or expenses. Indices are unmanaged and one cannot invest directly in an index.
-7
-6
-5
-4
-3
-2
-1
0
ETF minimized the effects of cash drag while maintaining liquidity for cash flow needsC
UM
ULA
TIVE
CAS
H D
RAG
PORTFOLIO WITH 5% CASH PORTFOLIO WITH 2% CASH & 3% ETF
JU
N0
9
JU
N1
0
JU
N1
1
JU
N1
2
JU
N1
3
SE
P0
9
SE
P1
0
SE
P1
1
SE
P1
2
SE
P1
3
DE
C0
9
DE
C1
0
DE
C1
1
DE
C1
2
DE
C1
3
MA
R1
0
MA
R1
1
MA
R1
2
MA
R1
3
MA
R1
4
JU
N1
4
-2.91%
-6.01%
-
CHAPTER 2.1 | 50
iShares offers 60+ National Association of Insurance Commissioners (NAIC) designated ETFs, more than any other provider.1 NAIC-designated ETFs help insurers:
Overcome regulatory hurdles by allowing more favorable Risk-Based Capital (RBC) treatment
Permit the ETF to be considered Long-term Bond Issuer Obligations as opposed to Common Stock on the statutory (Schedule D) filings
Maintain lower capital requirements to back their investments
1. Source: NAIC Purposes and Procedures Manual of the NAIC Securities Valuation Office. July 2013 Volume/Issue: 12/02.
The NAIC does not endorse or recommend any securities or products, including iShares ETFs. NAIC designations are issued for specific regulatory purposes and these designations are not equivalent to credit ratings issued by nationally recognized statistical rating organizations. NAIC designations are suitable only for NAIC members.
Source for NAIC definitions: NAIC Publicly Traded Securities Listing Definitions. For further NAIC definitions, please refer to the appendix or www.naic.org for additional information, as of 6/30/14.
ETF SPOTLIGHT:
iSHARES NAIC-DESIGNATED ETFs FOR INSURERS
Learn more at iShares.com/insurance
-
51
60+ iSHARES NAIC-DESIGNATED ETFs COVERING A VARIETY OF SECTORS:
LARGEST AND MOST COMMONLY USED NAIC-DESIGNATED ETFs:
NAME TICKER NAIC RATING AUM ($M) 20-DAYADV ($M)
iShares iBoxx $ Investment Grade Corporate Bond ETF LQD 2 $17,804 $112
iShares Core U.S. Aggregate Bond ETF AGG 1 $17,600 $106
iShares iBoxx $ High Yield Corporate Bond ETF HYG 4 $13,727 $252
iShares TIPS Bond ETF TIP 1 $13,181 $61
iShares 1-3 Year Credit Bond ETF CSJ 1 $11,870 $127
iShares J.P. Morgan USD Emerging Markets Bond ETF EMB 3 $5,191 $112
iShares Floating Rate Bond ETF FLOT 1 $3,568 $22
iShares National AMT-Free Muni Bond ETF MUB 1 $3,316 $19
SECTOR iSHARES ETFs
Broad 2
Government 11
Government/Credit 3
Credit 8
Corporate 4
Mortgage Backed Securities 3
High Yield 3
Emerging Markets Debt 4
Municipals 4
Inflation-Linked 4
Bullet Maturity 10
Short Duration 4
Preferred Equity 1
DESIGNATION iSHARES ETFs
NAIC 1 32
NAIC 2 18
NAIC 3 4
NAIC 4 6
NAIC P2 1
TOTAL 61
Source: BlackRock, Bloomberg, as of 6/30/14.
-
CHAPTER 2.1 | 52
A CIO of a pension plan was transitioning $1.7B in investment grade bond assets from a separate account to be managed in-house. However, the portfolio had thousands of holdings, with a large number of thinly traded securities. The CIO considered transitioning the portfolio into ETFs due to their operational efficiencies, including comparatively low management fees, monthly rebalancing to account for credit downgrades, and reinvestment of maturing issues.
BlackRock mapped the existing securities to an appropriate mix of iShares ETFs:
NAME TICKER ALLOCATION
iSHARES BID/OFFER SPREAD1
UNDERLYING BID/OFFER SPREAD1
PRICE IMPROVEMENT
iShares Barclays 1-3 Year Credit Bond ETF CSJ 10% 1 15 14
iShares Intermediate Credit Bond ETF CIU 20% 4 12 8
iShares 10+ Year Credit Bond ETF CLY 15% 11 50 39
iShares iBoxx $ Investment Grade Corporate Bond ETF LQD 55% 1 25 24
CASE STUDY:
TRANSITION MANAGEMENT USING ETFs
-
53
A strategy was developed to transition the entire portfolio of bonds utilizing the ETF structure, which allows for units to be created through an in-kind transfer process. The client delivered $1.5B in fragmented fixed income assets to their broker and in turn received ETF shares. The new ETF portfolio allows for transactional savings due to the tighter trading spreads of ETFs.
The remaining bondsapproximately $200M in less-liquid securitieswere sold by BlackRocks transition team, which used the proceeds to purchase additional shares of the ETFs for the client.
The customized ETF transition strategy helped pare the portfolio down from approximately 2,700 securities to 4 positions while providing broad exposure and the necessary diversification for the investment grade credit mandate. The resulting portfolio represented a substantial improvement in liquidity and operational efficiency.
1. Underlying bid/offer spread refers to the underlying securities of the respective index.Source: BlackRock, Bloomberg, Barclays, NYSE Arca, as of 6/30/14.
-
CHAPTER 2.1 | 54
1. Client delivered bonds to AP
2. AP delivered bonds to BlackRock
3. BlackRock delivered iShares ETFs to AP
4. Residual bonds liquidated in transition account
1. BlackRock Optimizer mapped existing bond portfolio
2. Residual bonds sent to transition account
INVESTMENT GRADE BOND
PORTFOLIO
BLACKROCK OPTIMIZER
iSharesETFs
Bonds
IMPROVING OPERATIONAL EFFICIENCY BY TRANSITIONING TO AN ETF PORTFOLIO
TRANSITION ACCOUNT
BLACKROCK
AUTHORIZED PARTICIPANT (AP)
CASE STUDY CONTINUED: TRANSITION MANAGEMENT USING ETFs
-
55
For illustrative purposes only. The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any of the strategies discussed will be effective. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.
1. AP delivered iShares ETFs to client
2. BlackRocks transition management team purchases additional shares of ETF with remaining cash and delivers to portfolio
CLIENTPORTFOLIO
CASH
LQD
CLY
CIU
CSJ
CASE STUDY CONTINUED: TRANSITION MANAGEMENT USING ETFs
-
2.2
KEY ETF INVESTMENT TRENDS:
PREPARE FOR RISING RATES
Recent ETF innovations have provided investors with the tools to better target duration risk and manage interest rate risk and credit exposure independently, providing greater flexibility in portfolio management.
Steve Laipply BLACKROCK FIXED INCOME STRATEGIST
-
CHAPTER 2.2 | 58
Long- and short-term interest rates have been in decline for the past 30 years, resulting in a sustained bull market for bonds. With global interest rates near historic lows, many investors have become concerned about the impact of rising interest rates on their fixed income portfolios.
While the timing, magnitude, and effects of a shift in the yield curve remain unclear, investors are exploring new ways to adjust their portfolios in the years ahead.
INTRODUCTION:
NAVIGATING AN UNCERTAINRATE ENVIRONMENT
-
59
Source: Bloomberg, as of 6/30/14.
30 YEARS OF DECLINING INTEREST RATES
10 YEAR TREASURY FED FUNDS TARGET RATE
0
5
10
15
20
19
71
19
75
19
79
19
83
19
92
20
01
20
07
19
87
19
96
20
05
20
11
20
13
19
72
19
76
19
80
19
84
19
93
20
02
20
08
19
88
19
97
20
06
20
12
20
14
19
73
19
77
19
81
19
85
19
94
20
03
20
09
19
89
19
98
19
74
19
78
19
82
19
86
19
95
20
04
20
10
19
90
19
99
19
91
20
00
INTE
RES
T R
ATES
(%)
-
CHAPTER 2.2 | 60
iShares ETFs allow investors to select the appropriate mix of duration risk, income potential, credit quality, and sector selection to implement their investment views.
Portfolios of bonds with coupons that reset with changes in a reference rate Potential for coupon payments to keep up with inflation Less interest rate sensitive than fixed coupon bonds Most effective when short-term interest rates are increasing
FLOATING RATE
iShares Floating Rate Bond ETFEffective Duration: 0.14 years
FLOTiShares Treasury Floating Rate Bond ETFEffective Duration: 0.01 years
TFLO
ETF SPOTLIGHT:
TOOLS FOR MANAGING DURATION
-
61
Source: BlackRock, as of 6/30/14.
Portfolios of bonds with maturities less than 5 years Offer precise exposure to credit, high yield, or Treasuries
iShares Short Treasury Bond ETFEffective Duration: 0.39 years
SHV iShares 0-5 Year Investment Grade Corporate Bond ETFEffective Duration: 2.52 years
SLQD
iShares 1-3 Year Treasury Bond ETFEffective Duration: 1.89 years
SHY iShares 0-5 Year High Yield Corporate Bond ETFEffective Duration: 2.18 years
SHYG
iShares 1-3 Year Credit Bond ETFEffective Duration: 1.92 years
CSJ iShares Core Short-Term USD Bond ETFEffective Duration: 2.71 years
ISTB
SHORT MATURITY
-
CHAPTER 2.2 | 62
Source: BlackRock, as of 6/30/14. Modified duration is shown for LQDH and HYGH, which uses a cash flow to worst calculation to match the hedge ratio in the fund.
Hedged bond portfolios that seek to mitigate interest rate risk Exposure to entire spread curve Reduce yield but lessen interest rate volatility
Actively managed multi-sector exposure Potential to enhance yield relative to cash
MULTI-SECTOR
NEAR iShares Short Maturity Bond ETFEffective Duration: 0.88 years
ICSHiShares Liquidity Income ETFEffective Duration: 0.33 years
iShares Interest Rate Hedged High Yield Bond ETFModified Duration: 0.04 years
HYGHiShares Interest Rate Hedged Corporate Bond ETFModified Duration: 0.13 years
LQDH
INTEREST RATE HEDGED
-
63
Designed with a defined maturity date and monthly income payments Exhibit declining durations over time Yield to maturity visible at time of purchase
CORPORATE
CORPORATE EX-FINANCIALS
MUNICIPAL
iBonds Sep 2015 AMT-Free Muni Bond ETFEffective Duration: 0.99 years
IBMD
iBonds Sep 2017 AMT-Free Muni Bond ETFEffective Duration: 2.82 years
IBMF iBonds Sep 2018 AMT-Free Muni Bond ETFEffective Duration: 3.66 years
IBMG
iBonds Sep 2016 AMT-Free Muni Bond ETFEffective Duration: 1.94 years
IBME
iBonds Mar 2016 Corporate Ex-Financials ETFEffective Duration: 1.28 years
IBCB iBonds Mar 2018 Corporate Ex-Financials ETFEffective Duration: 3.08 years
IBCC
iBonds Mar 2016 Corporate ETFEffective Duration: 1.27 years
IBDA
iBonds Dec 2016 Corporate ETFEffective Duration: 1.87 years
IBDF iBonds Dec 2018 Corporate ETFEffective Duration: 3.57 years
IBDH
iBonds Mar 2018 Corporate ETFEffective Duration: 3.07 years
IBDB
BULLET MATURITY
-
CHAPTER 2.2 | 64
A portfolio manager at a large registered investment advisor (RIA) wanted to reduce duration across her clients investment grade bond portfolios. At the same time, she wanted future income payments that would keep pace with short-term rates. The portfolio manager initially looked at bank loan ETFs as a way to lower duration, but was concerned about the liquidity risks and did not want to lower the credit quality of the portfolio.
After analyzing possible options, the portfolio manager implemented an allocation to iShares Floating Rate Bond ETF (FLOT), which holds securities that provide:
Investment grade credit quality Coupon payments that reset with changes in LIBOR Minimal interest rate risk
Additionally, the structure of the ETF offers:
Diversified exposure to more than 250 investment grade short-term floating rate bonds
Enhanced on-exchange liquidity relative to purchasing floating rate bonds in the OTC market
By reallocating 20% of investment grade bonds into FLOT, the duration of the portfolio was reduced from seven years to five years. In addition, FLOT has the potential to benefit from rising interest rates in the future.
CASE STUDY:
REDUCING INTEREST RATE RISK
-
65
FLOT CAN LOWER DURATION AND POTENTIALLY BENEFIT FROM RISING RATES
Source: Barclays Capital, Bloomberg, as of 6/30/14. 1. Fed Funds Target Rate is the interest rate that banks charge each other to borrow money.
The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any of the strategies discussed will be effective.
INTE
RES
T R
ATES
(%)
0
1
2
3
4
5
6
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
BARCLAYS US FLOATING RATE NOTE INDEX - AVERAGE COUPON
FED FUNDS TARGET RATE1
3 MONTH LIBOR
-
CHAPTER 2.2 | 66
Investors have traditionally accepted bundled interest rate and credit risk when investing in corporate bonds. This has made it challenging to directly express views on credit spreads.
While some investors attempt to isolate credit spreads with interest rate swaps and Treasury futures, managing these hedged portfolios can be time- and resource-intensive. Further, such strategies create additional costs and operational risks for investors.
The advent of interest rate hedged ETFs provides a simple instrument to efficiently separate interest rate and credit exposure. These strategies enable more precise control over a portfolios mix of interest rate and credit risk relative to short duration strategies.
INSIGHT:
HEDGE INTEREST RATE RISK TO MANAGE DURATION
-
67
CREDITRISK
INTERESTRATE RISK:Mitigated with short Treasury
futures
For illustrative purposes only. There is no guarantee that the Funds short positions will completely eliminate the interest rate risk of the long positions in bonds.
FIXED INCOME RISK COMPOSITION PROFILES
RIS
K C
OM
PO
SIT
ION
INTERMEDIATE DURATION BOND
Interest rate hedged bonds offer access to credit spread exposure directly
CREDITRISK
INTERESTRATE RISK
INTEREST RATE HEDGED BOND
SHORT DURATION BOND
CREDITRISK
INTERESTRATE RISK
-
CHAPTER 2.2 | 68
iShares Interest Rate Hedged ETFs offer diversified access to high yield and investment grade corporate bonds while seeking to mitigate interest rate exposure.
By actively managing a hedging strategy with short positions in Treasury futures, iShares Interest Rate Hedged Corporate Bond ETF (LQDH) and iShares Interest Rate Hedged High Yield Bond ETF (HYGH) provide a single trade vehicle to achieve targeted credit exposure.
Interest rate hedged ETFs can be used to diversify risk exposure in rate-sensitive portfolios, express credit spread views, and reduce the operational resources necessary to employ an in-house hedging strategy.
iShares Interest Rate Hedged Corporate Bond ETF
iShares Interest Rate Hedged High Yield Bond ETF
HYGH
LQDH
ETF SPOTLIGHT:
HEDGE INTEREST RATE RISK WITH THE SIMPLICITY OF AN ETF
-
69
For illustrative purposes only.
DYNAMICALLY MANAGE PORTFOLIO DURATION WITH HEDGED ETFS
Hedged PortfolioDuration=0
LESS INTEREST RATE RISK
MORE INTEREST RATE RISK
Unhedged PortfolioDuration=7.7
-
CHAPTER 2.2 | 70
With short-term rates close to 0%, cash investments may return negative real yields after inflation. Employing a liquidity tiering framework with ETFs can help investors meet cash flows while earning incremental yield with short duration investments. Investors should consider the following framework when balancing their need for principal protection and yield.
Tier 1 liquidity should be available for immediate use. The primary goal of Tier 1 cash is to protect against a principal shortfall.
Tier 2 liquidity does not need to be used immediately, but should be available over the next 6 to 18 months. The primary goal is income or yield, with a secondary consideration of principal protection. Tier 2 investments will likely contain some credit, liquidity, or interest rate risk in order to seek a potentially higher rate of return.
Tier 3 liquidity is reserved for longer-term (18+ month) liabilities and should have limited interest rate risk. The primary goal of this allocation is income, with the potential for capital appreciation.
Tier 2 and Tier 3 cash investments can be allocated to ETFs in order to increase yield and meet liquidity needs without sacrificing the principal protection in Tier 1.
INSIGHT:
LIQUIDITY TIERING FRAMEWORK FOR INCREMENTAL YIELD
-
71
PRIMARY GOAL
INVESTMENT HORIZON
LIQUIDITY TIER
INVESTMENT OPTION POTENTIAL SOLUTION
PRINCIPAL PROTECTION
INCOME OR YIELD
INCOME WITH GROWTH
TIER 1
TIER 2
TIER 3
Near-term 0-6 months
Intermediate -term 6-18 months
Longer-term 18+ months
Cash and stable NAV funds
Short duration bond fund with variable NAV but with potential to generate higher income
Short to intermediate duration bond fund with variable NAV but with potential to generate higher income with growth
Cash equivalentsManaged cash accountMoney market funds
ICSH: iShares Liquidity Income ETF
NEAR: iShares Short Maturity Bond ETF
FLOT: iShares Floating Rate Bond ETF
TFLO: iShares Treasury Floating Rate Bond ETF
SHV: iShares Short Treasury Bond ETF
ISTB: iShares Core Short-Term USD Bond ETF
CSJ: iShares1-3 Year Credit Bond ETF
SHY: iShares 1-3 Year Treasury Bond ETF
IBDA: iBonds Mar 2016 Corporate ETF
IBCB: iBonds Mar 2016 Corporate Ex-Financials ETF
SLQD: iShares 0-5 Year Investment Grade Corporate Bond ETF
SHYG: iShares 0-5 Year High Yield Corporate Bond ETF
LQDH: iShares Interest Rate Hedged Corporate Bond ETF
HYGH: iShares Interest Rate Hedged High Yield Bond ETF
TIERING CASH ALLOCATIONS
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CHAPTER 2.2 | 72
iShares Short Maturity Bond ETF (NEAR) is an actively managed strategy that seeks to maximize income through a multi-sector approach. The fund targets an effective duration of one year or less and is composed of at least 80% investment grade holdings.
The fund has the flexibility to invest in Treasuries, agencies, supranationals, corporates, MBS, CMBS, ABS, municipals, money market funds, investment companies, non-US dollar securities, 144A securities, and repurchase agreements.
NEAR is managed by a team of eight that have an average of more than a decade of portfolio management experience and are backed by BlackRocks Short Duration Portfolio Team, which has $55B under management.
ETF SPOTLIGHT:
SEEKING YIELD WITH LIMITED DURATION
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73
For illustrative purposes only. An investment in NEAR is not equivalent to and involves risks not associated with an investment in cash. Money market funds typically seek to maintain a net asset value of $1.00 per share. NEAR does not have a similar objective. Data as of 6/30/14 and subject to change. Past performance is no indication of future performance.
NEAR will invest in privately issued securities that have not been registered under the Securities Act of 1933 and as a result are subject to legal restrictions on resale. Privately issued securities are not traded on established markets and may be illiquid, difficult to value, and subject to wide fluctuations in value. Delay or difficulty in selling such securities may result in a loss to the iShares Short Maturity Bond ETF. The fund may invest in asset-backed (ABS) and mortgage-backed securities (MBS) which are subject to credit, prepayment and extension risk, and react differently to changes in interest rates than other bonds. Small movements in interest rates may quickly reduce the value of certain ABS and MBS.
CHARACTERISTICS
EFFECTIVE DURATION
AVERAGE CREDIT QUALITY
0.88 years
BBB+f
YIE
LD
DURATION
CASH INVESTORS
LONG FIXED INCOME INVESTORS
NEAR
SHORT DURATION
Invest frictional cash in NEAR to target a higher return than money market vehicles while maintaining intraday liquidity
Prepare for higher rates by shifting from longer duration exposures into NEAR to get a potentially higher yield versus short Treasuries
PUT CASH TO WORK REDUCE DURATION
-
2.3
KEY ETF INVESTMENT TRENDS:
BULLET MATURITY ETFs
We have seen growing interest in the bullet maturity ETF structure. Investors are using these funds in their existing fixed income portfolios, much the same way they use individual bonds.
Raman Suri HEAD OF BLACKROCKS iSHARES INSURANCE CLIENT GROUP
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CHAPTER 2.3 | 76
BUILDING AND MONITORING PORTFOLIO POSITIONS
PERFORMANCE DISPERSION
SINGLE ISSUE ILLIQUIDITY
PRICING TRANSPARENCY
CASH FLOW MANAGEMENT
INTRODUCTION:
COMPLEXITIES OF BUILDING BOND PORTFOLIOS
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77
Building portfolios is time-consuming in the fragmented OTC market Portfolios must be continuously monitored to account for credit
downgrades and defaults
Limited bond issue sizes pose obstacles to allocating the same security consistently across portfolios
Many bonds trade infrequently in secondary markets
Difficult to receive best execution in OTC market Must contact multiple dealers to estimate a fair market price Trading odd lots can be expensive
Bonds are often called away, requiring replacement Liquidating to meet unexpected cash flows can be costly
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CHAPTER 2.3 | 78
iBonds combine the features of a bond with the efficiencies of an ETF. iBonds are bullet maturity ETFs that provide diversified exposure to hundreds of bonds with maturities falling within specific years.
The unique combination of a defined maturity with the exchange tradability and diversification of an ETF makes iBonds ideal holdings to build new, or enhance existing, fixed income portfolios.
ETF SPOTLIGHT:
iBONDS: FEATURES OF A BOND, EFFICIENCIES OF AN ETF
BENEFITS OF AN ETF: Diversification across
hundreds of bonds in a single trade
More flexible trade lot sizes than individual bonds
Potential transactional savings versus buying individual bonds
Daily liquidity and trading efficiencies
FEATURES OF A BOND: Regular income
Final distribution at maturity
Clarity of yield at time of purchase
iBONDS
MATURE, LIKE A BOND TRADE, LIKE A STOCKDIVERSIFIED, LIKE A FUND
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79
IBDAMAR 2016
IBCBMAR 2016
IBMDSEP 2015
IBDH DEC 2018
IBCE MAR 2023
IBMGSEP 2018
IBCCMAR 2018
IBDF DEC 2016
IBME SEP 2016
IBDC MAR 2020
IBMH SEP 2019
IBDBMAR 2018
IBCD MAR 2020
IBMFSEP 2017
IBDD MAR 2023
IB MI SEP 2020
iBONDS CORPORATE ETFs
iBONDS CORPORATE EX-FINANCIALS ETFs
iBONDS AMT-FREE MUNI BOND ETFs
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CHAPTER 2.3 | 80
ETF SPOTLIGHT:
iBONDS HELP SIMPLIFY THE COMPLEXITIES OF BUILDING PORTFOLIOS
BUILDING AND MONTORING PORTFOLIO POSITIONS
PERFORMANCE DISPERSION
SINGLE ISSUE LIQUIDITY
PRICING TRANSPARENCY
CASH FLOW MANAGEMENT
iBONDS ETFs
-
81
Avoid sourcing in the OTC market Diversification across hundreds of bonds in a single trade Professional portfolio management monitors credit quality of
individual issues Monthly rebalancing to account for downgrades
ETFs trade intraday on exchange
Listed ETFs may be consistently allocated across portfolios
Trading spreads (bid/offer) are observable and measurable Pricing and fees are transparent Customizable trade size makes trading smaller allocations
cost-efficient
iBonds will not be called prior to maturity ETFs can be sold pro-rata to satisfy cash flows
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CHAPTER 2.3 | 82
Investors seeking the economics of a bond, such as regular income and a final principal payment for liability matching or bond laddering strategies, have historically turned to the OTC market. However, best execution may not be available when sourcing individual bonds in smaller trade sizes.
The potential transaction savings of investing in a diversified bullet maturity ETF can help preserve portfolio performance that would otherwise be eroded by high transaction costs.
The unique ability to buy/sell hundreds of bonds through bullet maturity ETFs at a lower cost relative to the OTC market can make iBonds a worthy alternative for investors trading smaller blocks.
INSIGHT:
SEEKING BEST EXECUTION FOR SMALLER FIXED INCOME TRADES
-
83
Source: BlackRock, TRACE, and Bloomberg. Average realized bid/offer spreads based on investment grade corporate bond trades tracked by TRACE between 1/1/14 and 5/31/14.
EXECUTION COSTS DEPENDENT ON TRADE SIZE
On average, small trades were more than 4X more costly than large trades when purchasing the same issues
0
10
20
30
40
50
60
70
80
90
100
TRADES OVER $1M TRADES UNDER $1M
AVE
RAG
E R
EAL
IZE
D B
ID/O
FFE
R S
PR
EAD
BONDS MATURING IN 2016
21
9
46
1315
69
95
6
BONDS MATURING IN 2018
BONDS MATURING IN 2020
BONDS MATURING IN 2023
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CHAPTER 2.3 | 84
ETF SPOTLIGHT:
APPLICATIONS FOR iBONDS
CORPORATE MUNICIPALSCORPORATE EX-FINANCIALS
iShares offers 16 iBonds ETFs that allow investors to: Target points on the yield curve Shift duration in a changing rate environment Build bond ladders Implement a liability-driven investment framework
DURATION
IBME
IBCBIBDA
IBDF
IBMD
IBMF
IBMG
IBMH
IBDHIBCD
IBDC
IBCEIBDD
IBMIIBCCIBDB
0 1 2 3 4 5 6 7 8
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85
iBonds bring trading and operational efficiency to bond laddering. Investors can easily access a diversified portfolio of investment grade corporate or municipal bonds in an exchange-listed security. By selecting an iBonds ETF to fit a specific maturity rung in a ladder, an investor can quickly allocate the same security across hundreds of portfolios without searching in the OTC market. If existing bonds in a ladder are called away, they can be replaced with a broadly diversified iBonds ETF.
BUILD OR ENHANCE BOND LADDERS
iBONDS SEP 2018 AMT-FREE MUNI BOND ETF
iBONDS SEP 2019 AMT-FREE MUNI BOND ETF
iBONDS SEP 2017 AMT-FREE MUNI BOND ETF
iBONDS SEP 2016 AMT-FREE MUNI BOND ETF
iBONDS SEP 2015 AMT-FREE MUNI BOND ETF
BUILD LADDERED PORTFOLIOS
5 ETFs = exposure to hundreds
of individual bonds
2018 BONDS: CALLED
2019 BONDS
2017 BONDS
2016 BONDS
2015 BONDS
STRENGTHEN BOND LADDERS
Replace single issues with a diversified
portfolio using an ETF
iBONDS MAR 2018 CORPORATE ETF
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CHAPTER 2.3 | 86
The CIO of a corporate pension adopted a liability-driven investment (LDI) strategy in order to meet regular pension benefit obligations. The CIO chose to use iBonds ETFs because they are designed to deliver the economics of a held-to-maturity bond with the liquidity and trading efficiency of an ETF.
The ability to view the expected yield to maturity at time of purchase allowed the CIO to precisely match the plans expected beneficiary payment obligations. Additionally, because iBonds trade on an exchange, the CIO was able to execute trades of all sizes quickly and efficiently.
The CIO reinvested each of the iBonds monthly distributions by purchasing more shares of the respective ETF. This avoided the common problem of trading odd-lot-sized positions or being forced to hold excess frictional cash when individual bonds make coupon payments or are called away. Additionally, iBonds are professionally managed and any underlying bonds that are downgraded are removed from the ETF on a monthly basis, requiring less operational oversight.
Utilizing iBonds ETFs, the client implemented and maintained a complex LDI framework consisting of broadly diversified, investment grade corporate bonds in an operationally efficient and cost-effective manner.
CASE STUDY:
LIABILITY-DRIVEN INVESTING WITH BULLET MATURITY ETFs
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87
LIABILITY MATCHING WITH iBONDS ETFs
iBonds Mar 2016 Corporate ETF (IBDA)
Matures
iBonds Mar 2018 Corporate ETF (IBDB)
Matures
iBonds Mar 2020 Corporate ETF (IBDC)
Matures
2016 Beneficiary Payment
2018 Beneficiary Payment
2020 Beneficiary Payment
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CHAPTER 2.3 | 88
iBonds are designed to provide a yield to maturity (YTM) profile comparable to that of the underlying bond portfolio. While individual corporate bonds pay interest semi-annually, iBonds provide monthly income payments and seek to preserve an investors anticipated YTM through a combination of monthly distributions and a final end-date distribution.
Unlike a bond, iBonds have neither a stated coupon nor a fixed par value due at maturity. If monthly distributions decline, the final distribution would be expected to help preserve the investors anticipated YTM. While the composition of cash flows may change, the yield that investors realize should be equivalent to their estimated acquisition yield (i.e., the yield at the time of purchase based upon the ETFs market price).1
Each iBonds ETF will terminate on its expiration date in the year of the fund name. As the underlying bond holdings mature in the final 12 months, the portfolio will gradually transition to cash and cash equivalents. After all the bonds in the portfolio mature, the ETF will delist from the exchange and make a final distribution to shareholders.
The regular income and final distribution payment of an iBonds ETF provide a similar experience to owning an individual bond.2
ETF SPOTLIGHT:
MECHANICS OF iBONDS
-
89
1. The ultimate realized yield to maturity would be impacted by the ETF price at the time of purchase, fund expenses, tracking error, credit events, and reinvestment of maturing proceeds through the end of the funds life. 2. An investment in the Fund(s) is not guaranteed, and an investor may experience losses, including near or at the termination date. The Funds do not seek to return any predetermined amount. 3. A schematic illustration representing the monthly distributions and final distribution of iShares iBonds and the semi-annual coupon payments and maturity distribution of corporate bonds.
INDIVIDUAL BOND CASH FLOW EXAMPLE3
$10
$100
$-100
~ 2%INVESTORYIELD TO
MATURITY ==
iBONDS CASH FLOW EXAMPLE3
$9.50
$-100
$100.50
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CHAPTER 2.3 | 90
Unlike a traditional ETF or mutual fund, the defined maturity profile of iBonds allows investors to estimate their expected annualized total return for the life of the investment.1
The iShares Estimated Net Acquisition Yield Calculator provides estimates of the total return of an iBonds ETF assuming it is held to maturity.
The tool to calculate the net acquisition yield is located on each iBonds product page at iShares.com.
Input potential purchase price to see the estimated breakdown of total net acquisition yield over the life of the holding.
The calculator takes the funds YTM, adjusts for any premium or discount relative to the NAV, and then subtracts the fund expense ratio to provide an estimated net acquisition yield.
ETF SPOTLIGHT:
ESTIMATING THE YIELD TO MATURITY OF iBONDS
ESTIMATED NET ACQUISITION YIELD CALCULATOR
1.Subject to risks assumed when investing in the fund or underlying securities.
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91
ESTIMATED NET ACQUISITION YIELD CALCULATORCalculate the Estimated Net Acquisition Yield (ENA Yield) based on the projected market purchase price that you input. This estimate also reflects the deduction of the expense ratio (10 basis points).
The NAV (as of 8/21/14) used in the calculation is $105.35. The value you enter should correspond to your estimated market purchase price as of 8/21/14.
Please note that the results generated by the Estimated Net Acquisition Yield Calculator are for illustrative purposes only and are not representative of any specific investment outcome.
The Average Yield to Maturity shown is the weighted average yield to maturity of the individual bonds. During the final year of the funds life, the underlying bonds will mature and the proceeds will be held in cash equivalents until the liquidation of the fund. The investors total realized yield to fund maturity will be influenced by the yield earned on these proceeds during the final year. If the future yield on cash equivalents is lower than the current Average Yield to Maturity for the portfolios bonds, the realized yield to fund maturity is also expected to be lower and vice versa.
Enter Price $ 101.59
CALCULATE
Average Yield to Maturity 3.19%
+ Price Adjustment +0.74%
= Price Adjusted Yield 3.93%
- Expense ratio (10 basis points) -0.10%
Estimated Net Acquisition Yield 3.83%
-
2.4KEY ETF INVESTMENT TRENDS:PURSUE GLOBAL OPPORTUNITIES
The desire for yield and enhanced diversification has led institutions to increasingly consider non-US fixed income investments. ETFs break down the barriers investors face when buying international bonds.
Brett Olson HEAD OF BLACKROCKS iSHARES EMEA FIXED INCOME
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CHAPTER 2.4 | 94
Given the backdrop of historically low US interest rates, international debt may offer an attractive investment opportunity. Adding international exposure has the potential to increase yield without assuming high levels of duration, which would be associated with similar-yielding domestic bonds. The inclusion of uncorrelated assets may reduce volatility and increase return potential for the overall portfolio.
However, investing internationally is rarely straightforward. Investors often face difficulties sourcing bonds, such as:
Establishing local custodial or brokerage relationships
Understanding and meeting requirements for owning local currency bonds
Navigating the restrictive tax policies of many countries
Because of these challenges, investors are increasingly turning to ETFs to gain exposure to international or emerging market debt. Fixed income ETFs allow investors to access difficult-to-reach areas of the global debt market through diversified and liquid vehicles.
INTRODUCTION:
UNLOCK GLOBAL INVESTMENT OPPORTUNITIES
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95
EXPOSURE CHARACTERISTICS
INTERNATIONAL DEVELOPED
EMERGING MARKETS
Potentially higher yields relative to US bonds Low correlation to US bonds Diversification across countries and sectors
Potentially higher yields relative to developed markets Low correlation to US bonds Higher exposure to credit risk Local currency exposure may increase returns, but adds volatility Increased price appreciation potential due to improving credit quality
of emerging market countries
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CHAPTER 2.4 | 96
ETF SPOTLIGHT:
DIVERSIFY WITH A GLOBAL OPPORTUNITY SET
International fixed income often exhibits correlations under 0.50 relative to US bonds. iShares offers a variety of exposures including US and local currencies, developed and emerging countries, and government and corporate sectors.
GLOBAL AND INTERNATIONAL DEVELOPED
TICKER iSHARES ETF FUND NAME
ITIP iShares International Inflation-Linked Bond ETF
GTIP iShares Global Inflation-Linked Bond ETF
IGOV iShares International Treasury Bond ETF
ISHG iShares 1-3 Year International Treasury Bond ETF
GHYG iShares Global High Yield Corporate Bond ETF
HYXU iShares Global ex USD High Yield Corporate Bond ETF
TICKER iSHARES ETF FUND NAME
EMB iShares J. P. Morgan USD Emerging Markets Bond ETF
LEMB iShares Emerging Markets Local Currency Bond ETF
CEMB iShares Emerging Markets Corporate Bond ETF
EMHY iShares Emerging Markets High Yield Bond ETF
EMERGING MARKETS
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97
Source: BlackRock, Bloomberg. Weekly correlations to the Barclays US Aggregate Bond Index are from 7/1/096/30/14. Correlation for LEMBs benchmark is calculated since 2/22/11, GTIP as of 12/31/09, and EMHY as of 12/7/11 because earlier data is not available.
DM/EM CURRENCY EXPOSURERATE
EXPOSURE GOVERNMENT CORPORATE IG/HYCORRELATION TO BARCLAYS AGGREGATE
Both Local Local IG 0.15
Both Local/USD Local/USD IG 0.44
DM Local Local IG 0.32
DM Local Local IG 0.16
DM Local/USD Local/USD HY -0.02
DM Local Local HY -0.03
DM/EM CURRENCY EXPOSURERATE
EXPOSURE GOVERNMENT CORPORATE IG/HYCORRELATION TO BARCLAYS AGGREGATE
EM USD US Both 0.26
EM Local Local Both 0.13
EM USD US Both 0.23
EM USD US HY 0.13
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CHAPTER 2.4 | 98
The investable emerging market debt universe is $2.8T, nearly 80% the size of the US investment grade corporate bond market.
iShares offers four ETFs to efficiently access diversified exposure to emerging market bonds.
BENCHMARK INDEX
SECTOR
CURRENCY
NUMBER OF COUNTRIES
NUMBER OF HOLDINGS
CREDIT EXPOSURE
S&P FUND CREDIT RATING
INCEPTION DATE
EXPENSE RATIO
AUM ($M)
NAIC RATING
DURATION (YEARS)
DESCRIPTION
ETF SPOTLIGHT:
iSHARES ETFs SIMPLIFY ACCESS TO EMERGING MARKET DEBT
-
99
Source: JPMorgan, Morningstar, and Barclays, as of 6/30/14.
DOLLAR-DENOMINATED EM DEBT
LOCAL CURRENCY EM SOVEREIGN
DOLLAR-DENOMINATED EM CORPORATE
DOLLAR-DENOMINATED EM HIGH YIELD
J.P. Morgan EMBI Global Core Index
Barclays Emerging Markets Broad Local Currency Bond Index
Morningstar Emerging Markets Corporate Bond Index
Morningstar Emerging Markets High Yield Bond Index
100% Government 100% Government 100% Corporate Government and Corporate
Investment grade and high yield
Investment grade and high yield
Investment grade and high yield High yield
USD Local USD USD
BB-f BBB-f BB-f Bf
5,191 608 21 206
45 21 35 39
12/17/2007 10/18/2011 4/17/2012 4/3/2012
3 2 3 4
258 166 161 284
0.60% 0.60% 0.60% 0.65%
7.10 4.20 5.47 5.75
EMB iShares J.P. Morgan USD Emerging Markets Bond ETF
CEMB iShares Emerging Markets Corporate Bond ETF
EMHY iShares Emerging Markets High Yield Bond ETF
LEMB iShares Emerging Markets Local Currency Bond ETF
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CHAPTER 2.4 | 100
An insurance company sought to add a 10% allocation to emerging market debt to improve diversification and enhance the yield of a $50M subsidiary account.
The $5M proposed allocation presented an operational challenge as it would require buying hundreds of individual bonds across dozens of countries, some of which had restrictive tax policies and prefunding requirements for trades in foreign currencies. However, the insurance company found hiring an investment firm to manage the allocation would be cost-prohibitive.
Consequently, the insurance company purchased $2.5M of iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) and $2.5M of iShares Emerging Markets Local Currency Bond ETF (LEMB). These ETFs provided immediate diversified exposure to emerging market debt across dozens of countries.
Another key benefit was the dual exposure to bonds denominated in US dollars (EMB) and local currencies (LEMB). This provided the insurer dollar diversification and an additional level of flexibility to adjust currency exposure.
EMB and LEMB also have NAIC 3 and 2 designations, respectively, assigned by the National Association of Insurance Companies, which assesses the credit quality of securities owned by insurers. A fixed income ETF that has been assigned an NAIC designation can be reported as a bond as opposed to a common stock, which is the default. This distinction allows for a more favorable risk-based capital (RBC) treatment.1
CASE STUDY:
ENHANCING DIVERSIFICATION AND YIELD
-
101
The ETFs allowed the insurance company to access difficult-to-source emerging market debt. The addition of the new asset class resulted in reduced portfolio volatility and enhanced yield.
TICKER iSHARES ETF FUND NAME SECTOR CURRENCYEXPOSURE# OF
COUNTRIES DURATIONNAIC
DESIGNATION
EMB iShares J.P. Morgan USDEmerging Markets Bond ETF Government USD 45 7.10 3
LEMB iShares Emerging MarketsLocal Currency Bond ETF Government Local 21 4.20 2
1. Source: BlackRock, based on NAIC guidance. The NAIC does not endorse or recommend any securities or products, including iShares ETFs. NAIC designations are issued for specific regulatory purposes and these designations are not equivalent to credit ratings issued by nationally recognized statistical rating organizations. NAIC designations are suitable only for NAIC members.
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CHAPTER 2.4 | 102
The NAIC does not endorse or recommend any securities or products, including iShares ETFs. NAIC designations are issued for specific regulatory purposes and these designations are not equivalent to credit ratings issued by nationally recognized statistical rating organizations. NAIC designations are suitable only for NAIC members. Source for NAIC definitions: NAIC Publicly Traded Securities Listing Definitions. For further NAIC definitions, please refer to the appendix or www.naic.org for additional information.
Note: The following indexes were used in the portfolios above: CreditBarclays Capital US Credit Bond Index; TreasuriesBarclays Capital US Treasury Bond Index; MBSBarclays US MBS Index; EM DebtJPMorgan EMBI Global Core Index, Barclays Emerging Markets Broad Local Currency Bond Index; AgenciesBarclays US Agency Bond Index. The example provided is strictly for illustrative purposes only and should not be construed as investment advice. The scenario is based on a firms specific request and outcomes are unique based on the firms situation. The information provided here may not be representative of other firms experiences. Past performance does not guarantee future results.
AGENCIES 1%
EM DEBT 5%
LOCAL EM DEBT 5%
MBS 23%
MBS 21%
TREASURIES 29%
TREASURIES 26%
CREDIT 47%
CREDIT 42%
AGENCIES 1%
IMPLEMENTING A 10% ALLOCATION TO EMERGING MARKET DEBT
BEFORE AFTER
CASE STUDY CONTINUED:ENHANCING DIVERSIFICATION AND YIELD
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103
Sources: BlackRock, MPI, as of 6/30/14. Index performance data as of 6/30/14. Index returns are for illustrative purposes only and do not represent actual iShares Fund performance. Index performance returns do not reflect management fees, transaction costs, or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
PORTFOLIO COMPARISON
3-YEAR STANDARD DEVIATION
5-YEAR STANDARD DEVIATION
Y