The Big Idea

Passive aggression

| May 10, 2024

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Even though fixed income ETFs have trailed competing mutual funds this year in growing assets under management, the bigger picture is steady growth for the ETF crowd. Since the start of 2022, taxable fixed income ETFs have added $422 billion in assets while mutual funds have lost $314 billion. ETFs still are only around a fifth of the fund total. But the market is seeing the effect of ETF growth in at least three circumstances: when ETFs are buying, when ETFs are selling or when ETFs are doing nothing at all.

Flows and balances

Taxable fixed income ETFs have added $68 billion this year through May 1, according to the Investment Company Institute, trailing the $98 billion raised by various mutual funds. Taxable investment grade mutual funds have led growth this year at $49 billion with multisector funds at $25 billion, global funds at $15 billion and government and high yield funds together at $8 billion.

Despite the gains for mutual funds this year, ETF growth has set the pace for much longer. ETFs have reliably added assets in recent years while growth in active funds has been much more variable (Exhibit 1). Nevertheless, coming into 2024, ETFs held $1.5 trillion in debt securities, according to the Fed’s Financial Accounts of the United States, while mutual funds held $5.2 trillion.

Exhibit 1: Growth of fixed income ETFs has run far ahead of active funds

Source: Investment Company Institute, Santander US Capital Markets

When ETFs are buying

While ETFs and mutual funds broadly sit on opposite sides of the passive-active management divide, the reality has some subtleties. The overwhelming majority of ETFs track a passive index, but an ETF can track active benchmarks such as a mutual fund, for instance, or the best relative value picks of a fund manager. Most mutual funds have the flexibility to stray from their benchmark index, but many nevertheless show big parts of their fund that track a market index closely. Nevertheless, it is safe to assume that ETFs are the more passive of the two types of funds and much more formulaic in structuring their portfolios.

Because ETFs try to mirror an index like the Bloomberg Aggregate US Bond Index, they become good buyers of any asset eligible for the index regardless of relative value. That includes the new issue flow in Treasuries, investment grade corporate debt and agency MBS. Rising ETF balances translate directly into rising demand for assets in proportion to their weighting in a market index.

Differences between debt issues eligible and ineligible for a major index also become more important as ETF balances rise. Debt issues with the size, rating or other features that qualify for a major index can draw much more capital than ineligible instruments. A richer valuation for an eligible issue probably says more about relative demand and liquidity than it does about fundamental relative value.

The more formulaic approach of ETFs should create more opportunity for active funds to take advantage of relative value. But a number of studies showing many active funds still hold large parts of their portfolio in assets that mirror their benchmark suggests less active management than the name implies.

When ETFs are selling

ETFs have also contributed to the rise in portfolios trading, where a fund sells not single securities but a portfolio of securities to meet redemptions and limit the need to rebalance the rest of the fund in the aftermath. Portfolio trading has raised the ante on good technology able to price and process these kinds of trades. Portfolio selling also can be the opposite side of the passive buying coin and again typically ignores relative value. This creates opportunities for active selling strategies, which some studies show can add as much value as traditional active buying.

The distinction between eligible and ineligible issues also shows up in ETF selling of issues that get downgraded and become ineligible for investment grade indexes. This is a challenge for mutual funds benchmarked to investment grade indexes as well, but ETFs may have less flexibility in their investment guidelines.

When ETFs are doing nothing at all

ETFs ironically have earned a role in active funds that need an efficient way to revert to an index weighting when the market seems to offer no clear opportunities for relative value. An active mutual fund can buy an ETF without the search time and transaction costs of assembling an index-neutral portfolio. But those ETFs then effectively set the price for the portions of any active portfolio that mirror the index. The more an active fund looks like its market index—that is, the more shadow indexing that goes on—the more the fees on the active fund should move toward the level of fees on the ETF. Those fees would likely not support the staff needed for active strategies. That leaves active mutual funds in a middle ground between ETFs and alternative asset managers, challenged by fees on one side and performance on the other.

ETFs still have a long way to go to catch up with the asset balances managed in mutual funds, but their faster rate of growth lately points to rising influence on the way the debt markets trade. ETFs have become another structural influence on asset value, much the way that banks and insurers shape the value of assets that fit their particular asset-liability or accounting preferences. That should be good news for relative value investors that can trade the opportunities created by formulaic investing.

* * *

The view in rates

Fed funds futures anticipate 34 bp of easing this year as of the Friday close, unchanged from a week ago. The market-implied probability of cuts at different meetings also are roughly unchanged. The market sees a 49% chance of September and a 52% chance of December. It’s still all about sticky inflation. Work by staff at the San Francisco Fed implies that tighter policy already has driven down inflation in price categories quick to respond to policy and may have a diminishing effect on remaining categories. In the aftermath of the latest FOMC, implied rate volatility continues to drop.

Other key market levels:

  • Fed RRP balances closed Friday at $486 billion, up $36 billion in the last week. RRP balances have bounced between $400 billion and $500 billion since the start of March. That range has held despite yields on most Treasury bills running well above the RRP’s 5.30% rate. One explanation could be the rise in balances at money market mutual funds. Those funds need to keep their weighted average life short, and RRP may be the best overnight game in town. The funds could be allocating some of their new inflows to RRP.
  • Setting on 3-month term SOFR closed Friday at 533 bp, unchanged on the week
  • Further out the curve, the 2-year note closed Friday near 4.87%, up 5 bp this week. The 10-year note closed at 4.50%, down 1 bp this week.
  • The Treasury yield curve closed Friday afternoon with 2s10s at -37, flatter by 6 bp this week. The 5s30s closed Friday at 13 bp, flatter by 4 bp over the same period.
  • Breakeven 10-year inflation traded Friday at 236 bp, unchanged this week. The 10-year real rate finished the week at 215 bp, also unchanged this week.

The view in spreads

Lower implied volatility after the latest FOMC should create more room for spreads in all risk assets to tighten a little further. Credit still has the most momentum with a strong bid from insurers and mutual funds, the former often funded with annuities and the later getting strong inflows in 2024. The broad trend to higher Treasury supply also helps in the background to squeeze the spread between risk and riskless.

The Bloomberg US investment grade corporate bond index OAS closed Friday at 87 bp, unchanged this week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 142 bp, also unchanged this week but volatile lately. Par 30-year MBS TOAS closed Friday at 38 bp, joining the parade of metrics unchanged this week. Both nominal and option-adjusted spreads on MBS look rich. Fair value in MBS is likely closer to 70 bp in OAS, so widening toward fair value looks reasonable.

The view in credit

Higher interest rate should raise concerns about the credit quality of the most leverage corporate balance sheets and commercial office properties. Most investment grade corporate and most consumer sheets have fixed-rate funding and look relatively well protected against higher interest rates—even if Fed easing comes late this year. Healthy stocks of cash and liquid assets also allow these balance sheets to absorb a moderate squeeze on income. Consumer balance sheets also benefit from record levels of home equity and steady gains in real income. Consumer delinquencies show no clear signs of stress. Less than 7% of investment grade debt matures in 2024, so those balance sheets have some time. But other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.

Steven Abrahams
1 (646) 776-7864

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

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