Since the beginning of the year, investors have been waiting anxiously for the Great Rotation to…well, rotate. So far, however, signs of the big turnaround have been pretty mixed. In fact, more are beginning to believe that signs aren’t really pointing to a rotation so much as a redistribution, as investors pull their money off the sidelines (money market funds) and shift it into equity markets. At least that’s what Cronus Futures Management’s Kevin Ferry told CNBC last week.
But while more and more investors are calling the Great Rotation out as a fake, bond exchange-traded funds (ETFs) are doing extremely well on rumours that the bond bubble is about the burst. According to BlackRock, exchange-traded bond funds took in $70 billion last year, a jump of 31.4% over 2011. Why? According to this article in Institutional Investor, a lot of institutional investors, including pension funds, are using ETFs as a quick way to get out of bonds on the day interest rates start to climb, taking a bite out of the value of bonds. In the great scramble to sell bonds, institutions are looking to ETFs as a fast and easy way to get out of the market.
It’s the liquidity sleeve move in action—but with a twist. Bonds are getting hard to sell. Much of the problem stems from post-2008 regulations that have forced banks out of the prop trading business. It’s meant that they’ve had to cut back on capital needed to maintain an orderly and liquid fixed income market. This has made the bond market all that more illiquid, so when rates eventually do start to rise, investors could be stuck with bonds they can’t sell very easily. Enter ETFs as a layer of bonds that can be swiftly unloaded.
If the popularity of bond ETFs is tied to expectations of a Great Rotation, however, they could get a reality check if, of course, you believe the rotation naysayers out there. As Leo Kolvakis pointed out last week on his blog, Pension Pulse, there are many big Canadian investors that are getting rid of their bonds (AIMCo and the Caisse to name just two). But he also points out that shorting bonds has probably been the worst trade of the year. Clearly, he’s not counting bonds out at this point.
So whither bond ETFs in 2013? The lack of liquidity in the bond space will likely continue to drive inflows, rotation or no rotation. And there are many factors that could drive investors back to risk aversion. Whatever happens, bond ETFs have certainly carved out an important space in a tough market.