It is the 21st of February 2020

What Happens To Bond ETFs When Interest Rates Go Negative?

Submitted by Nicholas Colas of DataTrek Research

Exchange traded funds continue to grow, exerting ever-greater influence on US capital markets. In equities, the issue is most pronounced in small caps (12-25% ownership) and real estate investment trusts (+13% for even the largest one). In fixed income, ETFs illuminate why investors put up with negative global interest rates. International bond ETFs still pay a coupon (however small), even when rates are below zero.

“US listed exchange trade funds are a market structure risk factor.” We have heard various iterations of that concern off and on for over a decade now. The basic argument goes like this:

  • ETFs promise tick-by-tick liquidity even though their underlying assets may be much less liquid.
  • As ETFs grow in popularity, this problem will only get worse.
  • If and when capital markets see another bout of volatility like 2008, ETFs will create market dislocations unseen in prior cycles.

There have been 2 notable (but brief) examples of this problem in the last 3 years:

  • The August 24 2015 flash crash of several hundred ETFs at the open. Markets were already choppy from a recent devaluation of the Chinese yuan, and many ETFs traded for +10% discounts to their NAV through much of the morning.
  • The February 5th 2018 spike in US equity volatility, which led to a vicious feedback loop between CBOE VIX-tied ETFs and the underlying contracts.

We have not heard much criticism of ETFs this month, but since we expect further market volatility today is a good time to review the US ETF ecosystem. Our usual 3-point format, headlined by questions to frame the discussions, with all data courtesy of

#1: What’s the latest on ETF assets under management and money flows?

  • US-listed exchange traded funds continue to grow in 2019.
  • AUM totals $3,944 billion across 2,295 exchange traded products (funds and notes). Fun fact: there have been more ETF launches thus far in 2019 (147) than IPOs (106).
  • Most of the total increase in AUM this year ($542 billion) has come from capital appreciation ($411 billion) rather than inflows ($131 billion).
  • YTD inflows are mostly to fixed income funds ($83 billion) rather than equities ($34 billion). Money flows are also positive for commodity/precious metals funds ($4 billion), real estate funds ($4 billion) and volatility-linked products ($3 billion).
  • Data from the Investment Company Institute - which included mutual fund money flows - shows that ETFs represent well over 100% of all equity fund inflows (MF’s are seeing redemptions), 87% of all commodity/precious metal inflows and 39% of all bond fund inflows.

The bottom line: ETFs continue to grow in popularity across all major asset classes in 2019.

#2: How much do equity ETFs own of various single stocks (i.e. how systematically important are they)?

  • The answer varies widely depending on the type of stock.
  • For the top 10 names in the S&P 500, the average ownership by ETFs is 6.8%. Among the important super cap Tech names, Microsoft is the most widely held stock by ETFs (7.0%), followed by Apple (6.5%), Amazon (6.3%) and Google/Facebook (6.2% each).
  • ETF ownership is much higher in the Russell 2000, with the top 10 names here averaging 11.4%. Dig down further, and ETF ownership percentages only rise. Stocks in the 25th percentile of the index by weight average 22.7% ownership by ETFs, for example.
  • As an asset class, Real Estate Investment Trusts have the highest percentage of ETF ownership. The 10 largest holdings in the Vanguard Real Estate Index Fund (the biggest ETF in the space by AUM) average 13.2% ETF ownership.

Bottom line: ETF ownership of US equities continues to climb (since inflows are positive and share counts go down with stock buybacks), and small caps/REITS show the largest “ETF effect”. Worth noting: US small cap ETF fund flows have been negative this year (-$886 million), and this group has underperformed US large caps, with $4 billion of inflows. There’s a chicken-egg problem with that sound bite analysis, but the relationship clearly exists.

#3: What happens to bond ETFs when interest rates go negative?

  • No need to explain why that’s a topical question just now.
  • The short answer is that negative yielding bonds still pay a coupon; the negative yield comes from principal erosion over time. Plunk down $120 for a bond that pays $1 annually and redeems at $100, and you’re out $10. That’s the negative yield, not a bill sent to every bondholder.
  • At present there are 11 international (non-US) bond US listed ETFs, with a total of $5 billion in AUM. Two – IAGG (iShares Core Intl Agg Bond) and BWX (SPDR Barclay Intl Bond) – are just over half that total.
  • By our calculation, the current yield on both is about 1.0% (BWX monthly payments have been stable, but IAGG’s are declining). Year to date price returns are 5-6% for the two.
  • ETF investors do not yet seem to be noticing the ever-lower payouts and availability of better options like US Treasury bonds. Fund flows for non-US bond funds are negative quarter-to-date, but only because of a $122 million redemption from one smaller fund (iShares IGOV). Aside from that, flows remain positive.

Bottom line: negative yielding bonds do not create negative yielding ETFs and mutual funds. Very low yields… Clearly. Principle risk… Yes, that much is actually guaranteed. But the exercise here is a useful reminder of why investors still buy “negative yielding” bonds.

Summing up: ETFs continue to grow in importance relative to how capital markets price securities. In equities, small caps and REITs are especially exposed. Bond ETFs – this year’s outsized winners in terms of inflows – are illustrative of why investors continue to buy even negative yielding bonds.

As for whether the continued rise of ETFs make markets less stable, history says they can contribute to temporary volatility. But let’s not forget that the S&P is 10% higher than last February’s VIX ETF meltdown and +30% higher than August 2016. Fundamental issues like interest rates and earnings still matter more.

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