How bond ETFs are shaping the trading landscape

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Meridy Cleary: Hi, you're listening to Market Matters, our market series here on J.P. Morgan's Making Sense podcast. I'm your host, Meridy Cleary from the FICC Market Structure team. And in today's episode, we're going to break down the credit ETF landscape, looking at what is driving demand and how these products are making fixed-income markets more resilient and accessible to a broader investment base. Here with me today, I'm joined by Matt Legg, global head of Delta One and ETF Sales, and Julie Abbott, head of North America ETF Sales. Hey, guys, thanks for joining me today.

Matt Legg: It's a pleasure. Thank you.

Julie Abbott: Thanks, Meridy. Great to be here.

Meridy Cleary: Yeah, it's great to have you guys. So Matt, let's start with you. A topic we've been monitoring in the market structure team is the evolution of the credit market, particularly around how credit instruments like corporate bonds and credit derivatives are evolving. Over the last decade or so, we've seen ETFs enter the fixed-income market, and since 2020, credit ETFs have hit really major milestones. Matt, how is the growing adoption shaping how these products are being traded from your perspective?

Matt Legg: Absolutely. So Bond ETFs have been growing for a number of years now. In fact, we'd have to say accelerating for a number of years and it's a global story. The strong asset growth in each region, U.S., Europe, and starting to accumulate in Asia. To give some numbers and some context, there's now around $2.5 trillion of assets in bond ETFs, and that's out of the $14 or so trillion of total AUM and ETFs. It's a really meaningful portion. And the milestones you mentioned, Meridy, are pretty recent as well. I remember when the industry, only five years ago, celebrated the milestone of AUM and fixed-income ETFs going through $1 trillion. Now we're at two and a half.

Meridy Cleary: Oh, wow.

Matt Legg: And they're not simply investment assets. They're being used as trading assets as well. In the U.S., fixed-income ETFs make up 15% of total ETF traded volume. And in Europe, even more so at 25% of total volume. That adds up to a really significant run rate. Currently, we're on track to execute $6 trillion of notional in fixed-income ETFs, meaning it's a really important asset class for all market participants.

Meridy Cleary: Wow. That's really interesting. And I'm curious in times of market volatility, if we think back to March 2020, or the SVB selloff, or even recent times of geopolitical events, what role can ETFs play during those periods?

Matt Legg: Well I think in those periods of time, investors are really looking for access to bond beta. That's what ETFs can provide. That's a really strong pull factor into the asset class. Increasingly, in periods of stress, we've actually seen ETFs pull liquidity and act as a price discovery instrument when underlying bond markets starting to dry up. And those events have actually acted as a proof of concept for ETFs as that liquidity instrument and as that price discovery instrument. And since then, we've seen accelerating usage with more investors relying on them to provide beta in those times of stress. It's been really common to see hedge funds, multi-asset investors, and a range of other investors manage their portfolio beta through ETFs, the same as they previously might have done with index TRS or with CDS products.

Meridy Cleary: Thanks, Matt. That's really interesting. And Julie, I'd love to hear your thoughts as well. If we contextualize the credit ETF landscape with the broader ETF ecosystem, in your view, what is the current structure of the market, and what are some of the differences between U.S. and European ETF markets?

Julie Abbott: Thanks, Meridy. Of course. So the U.S .ETF market is the largest in size globally and has grown to over 10 trillion U.S. dollars in assets across all asset classes. Specifically, fixed-income ETFs have grown to over 1.6 trillion. U.S. ETF volumes as a percentage of total volumes on average have made up a large amount of daily volume, 25 to 30% of the daily ADV compared to European ETF markets, which stand at approximately 16%. You also mentioned market volatility earlier. What we've observed is that in times of market stress, ETFs percentage of volumes tend to increase. In the U.S., for example, this number reached as high as 38% on August 5th of 2024.

Meridy Cleary: Interesting. And how are ETFs traded? If we think about the U.S. and Europe, how are they traded differently in those two jurisdictions?

Julie Abbott: Yes, it's a bit of a different story in Europe. The market structure is currently much more fragmented, partly because there is currently no consolidated tape. And therefore, we observe a much smaller percent of on-exchange ETF trading. The introduction of the EU consolidated tape is set to provide investors with a bit of a clearer picture of ETF trading and liquidity in the EU.

Meridy Cleary: Interesting thanks and let's get into some of the execution trends that you're seeing, Julie. How are market participants executing and how has this changed in recent years?

Julie Abbott: Yeah in the U.S., we observed three main execution types for ETFs. It's really block trading, request for quote, and on-exchange trading. Alongside larger ETF volumes, we're also seeing more and more instances of oversized block trades as a key trend. A block trade, as a reminder, is an off-exchange protocol that allows investors to trade a larger amount of shares and notional dollars in a single trade with more discretion. In fact, it now represents approximately 30% of all J.P .Morgan fixed-income ETF market volumes in the U.S.. This off-exchange activity is due to the comparatively fragmented European ETF market, as every ETF in Europe is able to be listed and traded across multiple exchanges across the continent.

Meridy Cleary: That's really interesting, thank you. And I'm curious how the investor base has evolved. We know that retail participation in ETF has picked up quite a bit since COVID. What about the institutional space?

Julie Abbott: In the U.S., ETFs have and continue to be the wrapper of choice for asset allocation decisions within the managed wealth space. ETFs are an attractive investment products because of their relatively low share price, which provides flexibility, intraday trading, and tax efficiency. The growth of the model portfolio market in the managed wealth space is also fueling the growth of ETFs. What we are observing is growing adoption of ETFs in the institutional space as well. A subsection of ETFs, especially fixed-income ETFs, have grown and are utilized like macro products alongside futures and swaps as part of the Delta One toolkit. The rise of portfolio trading due to the growth of ETFs has driven more demand in the institutional investor base as well.

Meridy Cleary: Innovation in the credit space has been pretty exciting to watch. The rise of credit portfolio trading, Julie, that you mentioned, has been a key trend in market structure. This is where a basket of credit instruments can be executed in a single trade. Matt, how is the rise of portfolio trading linked to the growth in credit ETFs?

Matt Legg: Well I mean, I think the portfolio trading in credit really has only become possible since or because of the growth of ETFs, or it's certainly, they're heavily codependent. So ETFs help portfolio trading in the sense that they provide a real-time level on a basket of bonds, and that basket of bonds essentially looks and feels like a portfolio trade. And because of this, ETFs are really commonly used as a central component of the pricing of that portfolio of bonds or of a portfolio of bonds. And when you're pricing up a portfolio of bonds, ETFs or the ETF levels are going to be one of the first inputs or components that's going to be used to help determine that level. Further to this, ETFs make up nearly 12% of the IG bond market, nearly a quarter, maybe even a quarter of the high-yield market. And so another way to think about this is that as well as providing pricing inputs and pricing transparency, the ETFs are also providing liquidity to a less liquid component of the market and are also providing liquidity to less liquid portions of the market and transparency to more opaque parts of the market. So certainly, a key component of the growth of portfolio trading.

Meridy Cleary: Interesting, and what you're saying is that this increased liquidity translates to the underlying bond market as well.

Matt Legg: Yeah, absolutely. We can look back to recent history, 2019 to 2023, credit ETF volumes nearly doubled. So really significant increases in the amount of activity in that wrapper, and that has fed through to liquidity to the underlying market. It's led to a large universe of bonds being traded in total and more volume being traded in those bonds. We can look back to a few data points since 2020, for example, the percentage of high-grade bonds that don't show a trace print over one week has dropped 2% from over 7% before. And similarly, if we think about the share of high-grade bonds that trade less than a million dollars a week, that's continued to decline, dropping from 30% in 2020 to under 17% today.

Meridy Cleary: Oh, wow.

Matt Legg: The additional liquidity that the ETF market provides is really allowing for larger-size portfolio transactions.

Meridy Cleary: Thanks, Matt. And Julie, a trend that I find quite interesting is that the majority of new ETF launches in 2024 have been actively managed. Could you explain this shift from passive to active? What types of investors are attracted to the active strategies?

Julie Abbott: Yeah, absolutely. It's actually a very interesting development. Actively managed strategies now represent over 60% of the new launches in each of the past four years and have taken in over 25% of all U.S. ETF inflows in the past year, which is really impressive. Their current assets under management in the U.S. has grown to over 800 billion year-to-date. And we really believe there are some major recent developments that have contributed to the growth of active ETFs. Number one, the introduction of the ETF for all, which really gives the expansion of the same regulation as for passive that allows active ETFs to use custom creation redemption baskets, which permit them to be more efficient in portfolio rebalancing and therefore more tax efficient. Also, the approval of the non-transparent and semi-transparent ETF structures, which really opened the door for active strategies. And those managers take a closer look at the ETF wrapper and feel more comfortable with the structure. Although they ultimately did not really adopt this one, they did go ahead and adopt the active transparent. Also, along the same time, the popularity of thematic strategies, especially disruptive innovation, as well as options-based ETFs have been a big driver. And then also the ease and ability to convert existing portfolios, such as mutual funds and separately managed accounts to the ETF wrapper have grown growth as well.

Meridy Cleary: Thanks, Julie. And something you mentioned there, ETF options certainly making headlines. Matt, can you tell us a bit more about how ETF options emerged and what benefits do they provide for investors?

Matt Legg: So the options market and the ETF markets have really started to intersect and they've intersected in two different areas. One is actually options on ETFs. So providing nonlinear returns on the ETF wrapper itself. And the other is the use of options within ETFs. So giving the ETF the ability to pass on a nonlinear return within the fund itself. So if we're thinking about the first, which I think was the direction of the question, there's been a very, very significant growth in options on ETF volumes traded. So looking at the U.S. and most of that growth as we'll come onto has been in the U.S., but looking at the U.S., there's been very significant volume growth. And there's a big, big range of possibilities of what you can trade options on within the ETF markets. 45% of the ETF market has a listed option on it. That makes up around 1,600 funds. So you've really got a broad range of possibilities to trade. That said, a lot of that volume is concentrated in quite a narrow set. So even though we're seeing big increases in volume, it's really coming principally in SPY, in Qs, in IWM, and actually those three ETFs represent around 95% of total options volume. So it's a good story in that there's lots and lots of volume in those, but it's a little bit narrow still. There's a wide range of possibilities, but it's still concentrated in the volume. The volume is still concentrated in a narrow set of funds. Going outside of the U.S., the picture is not quite as good. So it hasn't really been adopted in other markets in the same way it's been adopted in the U.S. There are some options available, but the liquidity and the volume is really not there yet. However, as with most things in the ETF market, we've tended to see the proof of concept and the growth occur in the U.S. and then that translates over to other markets. I do expect that to change going forward.

Meridy Cleary: That must bring about a lot of benefits, right?

Matt Legg: Absolutely. Obviously, having the ability to trade options changes the possible set of returns that the investor can access through ETFs and we look at the usage of options on ETFs and we can determine how investors are using them. Principally for ETFs, interestingly, they're using them for downside protection. And when we look at the put-call ratio of options trades, it's around 1.7 puts per call traded in ETFs. So as you can see, heavily skewing towards downside protection. If we compare that to single stock markets, it's more balanced. It's actually maybe slightly more calls to puts. Either a balanced use of upside versus downside or slightly more use for accessing upside. It's a different use case to single stocks, but clearly, investors are utilizing that options market to provide downside beta protection, which is obviously a great benefit to allowing them to protect their portfolios.

Meridy Cleary: And you also mentioned the use of options within ETFs. Can you tell us a little bit more about that?

Matt Legg:  So yeah, actually that's been growing pretty quickly as well. There's a range of funds which have been utilizing options to give investors access to nonlinear return streams, which as we know is one of the principal use cases of ETFs to give access to investors to a range of returns that would be otherwise challenging for them to access directly. The example here, the AUM in these funds has actually grown now to almost $115 billion. That's across 350 different funds. Over the past three years, that's a six-fold increase. Really rapid rise in the uptake and utilization of those type of funds by investors. And if we look into that and what investors are buying, call-put writing funds are the largest segment. They make up around 60% of the assets in options-based ETFs. And then second is buffer ETFs, which are put spread collar or collar overlay type strategies. That makes up around 36% of the AUM. As mentioned before, the value proposition of that is simply that investors get access to a return stream which would be challenging for them to hold otherwise.

Meridy Cleary: Okay, great. That's really interesting. And earlier we mentioned the consolidated tapes in Europe, as some of our listeners may know, the consolidated tapes have been decades in the making. Matt, how impactful do you think, in the context of the ETF market, could these tapes be for European markets?

Matt Legg: I think it could be very impactful. I think Julie already mentioned the lack of on-exchange liquidity in Europe relative to the U.S., and that's a commonly known and appreciated problem, and lots of people have been working to try to address that for a period of time. The fact that there's not a lot of on-screen liquidity doesn't mean that the ETFs are not actually liquid. It's most dealers, or it's very common to access liquidity for the ETFs by accessing either the liquidity of the underliers or by accessing proxy assets like futures or index swaps or various other ways of getting access to the underlying returns of the ETF, and thereby providing liquidity in the ETF itself. The ETFs can be very liquid, it just doesn't display that on-screen, and the consolidated tape has been one of the solutions that's been put forward to help address that issue. We took a big step towards that after MiFID II, there was a requirement for all ETF trades to print, and therefore all of these OTC trades which were occurring, and there were lots of OTC, lots of liquidity in OTC markets on these ETFs, they all needed to print. And so at least, there was an ability to pull together all of the traded volume and actually see that, but to do that, you have to access it from all the different venues. The idea behind the consolidated tape is simply that it will pull it together and make it more obvious and more accessible for everyday investors to see, and therefore remove some of the questions around the illiquidity of ETFs in Europe, which is not representative of the true liquidity accessible in the product.

Meridy Cleary: We've covered a lot today, so thank you so much Matt and Julie for your insights.

Matt Legg: Thanks, Meridy.

Julie Abbott: Thanks, Meridy.

Meridy Cleary: And to our listeners, please stay tuned for more FICC market structure and liquidity strategy content here on J.P. Morgan's Making Sense podcast. If you're a J.P. Morgan client and have any questions or would like any further information on the topics we discussed today, please reach out to your J.P. Morgan sales representative. I hope you have a great day.

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