fixed income etfs: fact vs. fiction...3 has the increasing size of the fixed income etf market...

Fixed Income ETFs: Fact vs. Fiction Answers on Fund Structure, Liquidity, Trading and Performance

EducationFixed Income

June 2020

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Contents3 Has the Increasing Size of the Fixed Income

ETF Market Distorted the Bond Market? 6 Are Fixed Income ETFs Sufficiently Liquid?

9 Did Fixed Income ETFs Pass the Global Pandemic’s Test?

11 Do Fixed Income ETFs Overweight the Riskiest Companies?

13 Do Fixed Income ETFs Underperform Active Managers in Volatile Markets?

15 Did the Federal Reserve Buy ETFs in 2020 to Shore up the ETF Market?

17 Are There Too Many Bonds to Make Fixed Income Index Investing Efficient?

19 Are Fixed Income ETFs Difficult to Trade?

3

Has the Increasing Size of the Fixed Income ETF Market Distorted the Bond Market?

Despite their rapid growth, fixed income ETFs still only represent 2.1% of the total investable fixed income universe and 5.4% of the US high yield market.

However, in some fixed income sectors, ETFs are rapidly becoming an important source of additive liquidity.

The fixed income ETF market is still relatively young — the first fixed income ETF launched in 2002. Only 10 years ago, assets under management in fixed income ETFs represented $48 billion and circa 1.9% of the global fixed income fund industry, according to Morningstar. Meanwhile, ETFs accounted for a mere 0.2% of the investable global fixed income universe as measured by the Bloomberg Barclays Multiverse Index, which includes investment-grade and high yield bonds issued in developed and emerging market currencies.

As of June 30, 2020, fixed income ETFs represented 15% of the global fund market, with nearly $1 trillion in assets. While the growth of these instruments has been robust, they still “only” account for 2.1% of the total investable fixed income universe.1 Flows have been strong, but they have not occurred solely at the expense of other types of existing investment vehicles. They have grown the overall market.

When it comes to their impact on market prices, these instruments still represent a relatively small portion of sub-asset classes within the fixed income market. Figure 1 highlights some examples of the difference between how much ETFs represent of the actual investment universe, and Figure 2 shows how much they account for in terms of trading activity.

Fixed Income ETFs Fact vs. Fiction

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4

Figure 1 Relative Sizes of ETF AUM Versus Total Market AUM ($m)

US High Yield

Corporate Bonds

US Investment

Grade Corporate

Bonds

US Investment

Grade Floating

Rate Notes

US Senior Loans

US Municipal Bonds

EM Bonds US Government

Bonds

US MBS

Market Size (M)

$1,383,438 $8,463,912 $383,289 $1,184,956 $3,864,160 $2,230,126 $17,153,997 $6,441,078

ETFs AUM (M)

$65,879 $199,116 $9,075 $7,078 $53,737 $24,825 $180,762 $41,857

ETF Market Share (%)

4.80% 2.40% 2.40% 0.60% 1.40% 1.10% 1.10% 0.60%

Market Size Data: SIFMA (as of Q2 2020; US IG Corporate Bonds, US Government Bonds, US Municipal Bonds), Bloomberg (as of 06/30/2020. US High Yield Corporate Bonds, US IG FRNs, EM Bonds, US MBS, Convertible Bonds), The Loan Syndications & Trading Association (as of 06/30/2020; US Senior Loans), S&P Dow Jones Indices (as of 12/31/2019; US Preferred Stocks) ETF AUM: Bloomberg Finance, L.P., (as of 06/30/2020). Average Daily Volume (3M ADV) Bond Trading: Bloomberg Finance, L.P. , (as of 06/30/2020), EMTA (as of Q1 2020; EM Bonds), SIFMA (as of 06/30/2020; US Government Bonds, US Municipal Bonds, US MBS), S&P Dow Jones Indices (as of 12/31/2019; US Preferred Stocks), BondCliq (US IG FRNs, as of 03/31/2020). Average Daily Volume (3M ADV) ETF Trading: Bloomberg Finance, L.P., (as of 06/30/2020). Trading Stats Source:Source: Bloomberg Finance L.P., as of 06/30/2020.

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US High Yield Corporate Bonds

US Investment Grade

Corporate Bonds

US Investment Grade

Floating Rate Notes

US Senior Loans

3M ADV: ETF Trading (M)

$16,703 $29,297 $1,167** $3,305

3M ADV: Bond Trading (M)

$4,054 $3,505 $101 $225

ETF Trading Volume (%)

24.30% 12.00% 8.50% 6.80%

** As of 03/31/2020. Market Size Data: SIFMA (as of Q2 2020; US IG Corporate Bonds, US Government Bonds, US Municipal Bonds), Bloomberg (as of 06/30/2020. US High Yield Corporate Bonds, US IG FRNs, EM Bonds, US MBS, Convertible Bonds), The Loan Syndications & Trading Association (as of 06/30/2020; US Senior Loans), S&P Dow Jones Indices (as of 12/31/2019; US Preferred Stocks) ETF AUM: Bloomberg Finance, L.P., (as of 06/30/2020). Average Daily Volume (3M ADV) Bond Trading: Bloomberg Finance, L.P., (as of 06/30/2020), EMTA (as of Q1 2020; EM Bonds), SIFMA (as of 06/30/2020; US Government Bonds, US Municipal Bonds, US MBS), S&P Dow Jones Indices (as of 12/31/2019; US Preferred Stocks), BondCliq (US IG FRNs, as of 03/31/2020). Average Daily Volume (3M ADV) ETF Trading: Bloomberg Finance, L.P. (as of 06/30/2020). Trading Stats Source:Source: Bloomberg Finance L.P., as of 06/30/2020.

Figure 2 3-Month Average Daily Volumes Bond Trading vs. ETF Trading

Trading Volumes ETFs generally account for <5% of assets in almost all segments of the broad USD fixed income universe; in many cases, however, these instruments represent a higher proportion of the traded volume. Thus, the fixed income ETF can be a source of additive liquidity to those markets. The stock exchange becomes the venue where a variety of investor types congregate to position their portfolios and express a fixed income beta exposure in either direction. This two-way flow in shares of the ETF typically results in muted impact on the underlying market. (For example, an ETF consisting of senior loans or high yield bonds may see only $1 of net share creation or redemption for every $6-8 of secondary trading value). In high yield, ETF trading may have begun to supplant volumes in synthetic products, such as total return swaps and credit derivative swap indices (CDX); investors often prefer the funded exposure due to its performance profile, which better matches the cash bond market and avoids the multiple basis risks that exist with a synthetic exposure.


6

Are Fixed Income ETFs Sufficiently Liquid?

A fixed income ETF’s liquidity is at least as liquid as the underlying market that it tracks.

The ability to invest in an ETF via the primary and/or the secondary market can provide greater liquidity compared with alternative approaches to bond investing, such as index and actively managed mutual funds.

The unique structure of a fixed income ETF — which packages a diversified portfolio of bonds into a single, tradable equity — provides two sources of liquidity for investors. These two sources — ”primary,” which can be accessed via an authorized participant, and ”secondary,” which can be accessed directly — define a fund’s overall liquidity profile.

Primary market An ETF is a portfolio of individual securities — i.e., equities or bonds — that form a single fund. The shares of this fund are publicly listed and trade on an exchange (the secondary market). Normally, investors buy or sell ETF shares via the secondary market. However, if their buy or sell order is too large to trade on the exchange, an alternative approach could be for the investor to approach a market maker, who in turn, could trade via the primary market. The size of the investor’s order and trading volumes of the ETF will determine whether the secondary market can accommodate the trade. If the investor could only trade via the secondary market, a large order may take time to execute, meaning they would be exposed to market risk for an extended period.

To counter this potential problem, ETF issuers partner with a pool of authorized participants (”APs”), who, through managing the primary market, ensure that investors can buy or sell shares in the ETF in various market environments. These APs are also known as “market makers”: their role is typically carried out by investment banks or specialist trading firms. APs are able to create new shares for the ETF in the case of a large buy order (“creation”) and redeem existing shares in the case of a large sell order (“redemption”). This intraday mechanism is called creation/redemption and means that ETFs are able to accommodate large buy or sell orders beyond the liquidity provided by the secondary market.

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7

Case Study: US High Yield Liquidity

US High Yield liquidity is occasionally highlighted as a potential area of concern, particularly for ETFs in times of market stress. However, analysis of the market’s trading volume reveals that ETFs actually complement the broader market’s liquidity profile. Figure 3 shows historical high yield market trading volumes and illustrates how both types of ETF liquidity – primary and secondary market volumes — are dwarfed in comparison with the broader HY cash market. It demonstrates how, in periods of market stress, ETF secondary trade volume tends to spike, but the primary market volume remains relatively subdued in comparison. This suggests that even in times of market stress, there is sufficient secondary market ETF liquidity for investors to trade without accessing the primary market and, subsequently, the broader market. It also highlights that, if large numbers of investors tried to redeem at the same time, the primary ETF market could be used as a liquidity source, especially given the scale of trading volume in the US HY cash market. Even in times of severe market volatility, there was sufficient liquidity in the secondary market to allow investors to buy and sell their positions without relying on the primary market. As shown in Figure 4, fixed income ETFs are the only investment vehicle that provides two layers of liquidity and offers transparent, diversified access with intraday pricing.

This creation/redemption mechanism facilitates instantaneous an order executed in size and at a price level that the underlying bond market supports. For example, if an AP has the ability to buy and sell $1 billion worth of US Treasuries, that AP should be willing to make an equivalently sized market in a US Treasure ETF — even if the fund has a low average daily trading volume and small AUM. The liquidity of a fixed income ETF is therefore at least equal to the liquidity of the underlying bond market.

Secondary market The secondary market is simply the exchange where ETFs are listed and trade. An ETF’s secondary market liquidity can be assessed by looking at its average daily trading volume and spread (i.e., the difference between the offer price and bid price, which are the prices at which investors can buy or sell the fund), as well as premiums and discounts to net asset value. As outlined above, the full scale of an ETF’s liquidity can only be accurately measured when the primary market’s liquidity is also included.


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Figure 4 Trading Comparison Across Investment Types

Figure 3 High Yield Volume vs. High Yield ETF Primary Market Activity

HY ETFs Primary Volume ($)

HY ETFs Secondary Volume ($)

HY Cash Volume ($)

Billions ($)

0

25

15

10

20

Jun2016

Feb2017

Oct2017

Jun2018

Feb2019

Oct2019

Jun2020

Brexit induced Volatility: HY ETFs Trade an Average of 3Bn/day for an Entire Week

JNK Sets New Record Volumes in Jan & Feb

Q4 2018 Market Sell Off: HY ETFs Trade $8Bn in a Day

Covid Volatility: HY ETFs trade

$12Bn+ the last day of Feb

Source: Bloomberg Finance, L.P., as of 06/30/2020. For illustrative purposes only.

Exchange Traded Fund

Index Fund

Actively Managed Fund

Single Fund

Trading venue On Exchange (secondary) Primary Market

Via fund provider, requiring written application

Via fund provider, requiring written application

Over the counter, voice or electronically enabled

How frequently can investors gain access?

Intraday Typically close of business on trade date

Typically close of business on trade date

Intraday

Trade notification period

None Typically 1 to 3 days

Typically 1 to 3 days

None

Minimum investment size

1 share Fund’s Minimum Investment Size

Fund’s Minimum Investment Size

Bond’s Minimum Price/Minimum Increment

Can investors see intraday pricing?

Yes No No Yes

How concentrated is the portfolio?

Diversified Diversified Greater concentration

Single security

Source: State Street Global Advisors, as of 07/31/2020. For illustrative purposes only.

9

Did Fixed Income ETFs Pass the Global Pandemic’s Test?

A discussion of fixed income ETFs being tested typically centers on the pricing of ETFs, and any associated premium or discount that may arise between the market price quoted on the exchange and the end of day Net Asset Value (NAV).

At its most basic level, an ETF’s NAV reflects an estimate of the value of an ETF’s underlying portfolio. Typically, that NAV is fairly accurate. However, in a volatile market, lack of price transparency in fixed income securities will impact the estimate of the fair value of that basket of bonds. When underlying fixed income market liquidity becomes constrained, pricing becomes increasingly opaque and market fragmentation is exacerbated. And individual bond pricing can lag real-time market sentiment as well as realistic pricing levels.

Real-time sentiment, however, will show up in fixed income ETF market prices where the market deems that basket of bonds should trade, based on prevailing macro information and balances at the supply and demand equilibrium point.

When premiums and discounts become more pronounced during periods of volatility, fixed income ETFs’ Net Asset Value (NAV) pricing can be considered stale. However, the discount simply reflects the fair market price between willing buyers and sellers based on their assessment of the valuation of the underlying bonds — some of which may not have traded recently. So, what first appears to be an “issue” with fixed income ETFs, is structurally what should be expected when investors use ETFs as price discovery tools.

Structural factors can also lead to more pronounced premiums and discounts during periods of volatility. Fixed income NAV prices are typically struck as of 3 p.m. EST — and ETF trading that continues from 3 to 4 p.m. can lead to distorted premiums/discounts relative to those NAVs struck at 3 p.m. Importantly, market-moving news that breaks after 3 p.m. may impact the level of a fixed income ETF’s discount, as the market is incorporating real-time news while the underlying NAV is already struck. Overall, large discounts in fixed income ETFs likely reflect market participants’ inability to trade underlying bonds at levels reflected in (potentially stale) NAV valuations. Therefore, the ETF’s price may better reflect actionable prices to trade constituents.

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Volatility Draws Investors to Fixed Income ETFs

During the Q1 2020 COVID-19 induced volatility, liquidity dried up across fixed income markets. Even the most liquid markets such as US Treasuries exhibited signs of stress.

However, during this period, fixed income ETFs had record trading volumes. Their transparent secondary market trading provided price discovery and a liquid tool for transferring risk, when most other risky asset types in the space offered little liquidity. Used to make real-time asset allocation decisions, fixed income ETFs provided liquidity at a time when investors demanded it most.

Fixed income ETF trading volumes set a new record in March, trading an average of $34Bn per day during the month, with IG credit ETFs trading $6.1Bn and HY Corp ETFs trading $6.6Bn, up 86% compared to the prior two months for the corporate bond ETF category.2

From February 24–March 31, when the CBOE Volatility Index (VIX), a popular measure of the stock market's expectation of volatility based on S&P 500 index options, increased to an average of 53, the SPDR® Bloomberg Barclays High Yield Bond ETF (JNK) traded over $2B on six of the days in that period, including $2.9B on February 28. Prior to the spike in volatility, JNK volumes were 4.9% of the underlying HY cash market volumes. When volatility came to market, JNK volumes spiked to 8.4% of underlying HY bond volumes on average, with a high of 15.4% on February 24.3

Seeming to gain investors’ confidence, fixed income ETFs posted four consecutive months of inflows greater than $20 billion from April 2020 to July 2020 — a record streak for this asset class.4 Equity ETFs have not seen this degree of inflows in any period over the past five years. Record fixed income inflows combined with positive market movement (core bonds, IG credit, and high yield have all had positive returns year to date in 2020), pushed assets under management for US-listed fixed income ETFs to over $1 trillion for the first time, as investors leveraged fixed income ETFs to recalibrate portfolios based on prevailing macro trends.5

While some fixed income ETFs saw short-lived divergences between their price and NAV, investors have come to understand the reasons for this perceived dislocation and now recognize the risk-clearing price as a better representation of asset class valuation. They understand what happens structurally when ETFs are used as price discovery tools. And the persistent and sizeable inflows since the onset of the pandemic reflect investors’ confidence in the fixed income ETF structure – a sign that fixed income ETFs passed the latest, and most significant, volatility test.

Figure 5 Fixed Income ETF Monthly Flows Versus Assets Under Management

Monthly Flows

Total AUM

Source: Bloomberg Finance L.P., State Street Global Advisors, as of July 31, 2020.

300

1,100

1,000

900

800

700

600

500

400

AUM ($ Billions)Fund Flows ($ Billions)

-30

40

30

20

10

0

-10

-20

Jan2015

Jul2015

Jan2016

Jul2016

Jan2017

Jul2017

Jan2018

Jul2018

Jan2019

Jul2019

Jan2020

Jul2020

11

Do Fixed Income ETFs Overweight the Riskiest Companies?

An ETF’s index construction inherently provides diversification benefits and often employs constituent capping to mitigate concentration risks.

In addition to the broad diversification afforded by indices, large issuers of debt are also companies with substantial asset bases and revenue profiles. This provides the ability, or the capacity, to pay and service the debt on the firm’s balance sheet. Focusing only on the amount of debt an issuer has in an index overlooks a few key variables.

Indices are rules based, focusing on diversification and liquidity for ensuring investability. As a result, not all of an issuer’s debt is included in an index, which paints an incomplete picture of the firm’s overall indebtedness. For instance, an issuer can have short-term liabilities that do not qualify it for inclusion in an index, or debt financing secured in subordinated form, or financing denominated in a different currency.

As shown in Figure 6, based on the amount of debt included in the Bloomberg Barclays US Corporate Bond Index, the rankings of the most indebted firms are very different from the rankings of their total short and long debt overall.

A high level of debt for an issuer has little to do with a company’s creditworthiness or capacity to pay.

Firms with larger debt loads do not pose greater risks for investors than firms with smaller debt loads. If it were the case that large debt loads equated to greater credit risk, the corporate bond market would exhibit a linear relationship between credit ratings and debt outstanding. However, credit rating agencies consider numerous factors besides amount of debt, including capacity to service debt.

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Diversification does not ensure a profit or guarantee against loss.

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Figure 6 Top 10 Holdings in the Bloomberg Barclays US Corporate Bond Index

Weight in Index (%)

Rank by Debt Included

in Index

Rank by Short-Term

and Long-Term Debt

Market Cap ($M)

Sales (Last 12M) ($M)

Bank of America Corp 2.21 1 20 215,562 113,613

JPMorgan Chase & Co 2.20 2 17 294,521 149,796

AT&T Inc 1.69 3 44 210,758 181,265

Wells Fargo & Co 1.66 4 30 99,940 109,460

Citigroup Inc 1.63 5 18 104,116 103,528

Goldman Sachs 1.49 6 25 70,434 56,422

Morgan Stanley 1.38 7 29 77,040 63,303

Comcast Corp 1.38 8 61 195,515 108,942

Apple Inc 1.28 9 70 1,820,846 259,968

Oracle Corp 1.21 10 90 170,065 39,068

Source: Bloomberg Finance, L.P., as of 07/31/2020. This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown. It is not known whether the sectors or securities shown will be profitable in the future.

13

Do Fixed Income ETFs Underperform Active Managers in Volatile Markets?

Index-based fixed income exposures would have outperformed 77% of active managers, on average, during six systemically important volatile markets over the past 26 years.

SPDR ETFs analyzed six significant market events representing periods of volatility in the bond markets over the past 26 years: the Aggressive Fed Hike, the Tech Bubble, the Global Financial Crisis, the Taper Tantrum, the 2016 plunge in oil prices, and COVID-19.

The analysis focused on the performance of active managers within the Morningstar Intermediate Core Bond and Intermediate Core-Plus Bond Universes and found that fixed income index-based exposures outperform active strategies.

As shown in Figure 7, the Agg outperformed the median manager in each of the events. In fact, during three of the volatile events, the index ranked in the top quartile. The belief that index-based exposures cannot withstand market volatility is clearly a misconception — the Agg outperformed more active managers than it underperformed.

Why have index-based strategies proven so resilient? During a downturn, spreads widen and default rates increase, while the flight to safety means that Treasuries are in demand. Unfortunately, any active manager with an overweight to credit and, therefore, a higher credit beta, may be negatively impacted as default rates spike. Managers who outperform the benchmark during an upmarket tend to be unable to market time a downturn and reduce risk as all investors are leaving the party. These active managers’ credit exposure hurts performance during risk-off environments. Active strategies also tend to be more concentrated, whereas indexing provides a broader exposure, which potentially lowers idiosyncratic risk during market volatility through diversification.

This analysis does not preclude the implementation of both active and index exposures for efficient portfolio construction. Over the long term, there is clearly a place for both; index-based exposures can augment active exposures, thus benefiting long-term performance while lowering fees.

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Figure 7 Performance During Market Turbulence Index vs. Active Managers

Bloomberg Barclays US Aggregate Bond

Manager Universe, Morningstar Intermediate Core and Core-Plus Bond:

Top Quartile

Median

Bottom Quartile

Source: Morningstar as of 06/30/2020. The information contained above is for illustrative purposes only. Weights are as of the date indicated, are subject to change, and should not be relied upon as current thereafter. Diversification does not ensure a profit or guarantee against loss. Past performance is not a reliable indicator of future performance.

COVID-1901/01/2020–06/30/2020

6.1%

6.2%

5.3%

3.7%

Taper Tantrum05/1/2013–08/30/2013

-3.7%

-3.3%

-4.0%

-4.5%

Tech Bubble1/1/2000–02/28/2003

10.1%

9.7%

8.9%

8.1%

Aggressive Fed Hike2/1/1994–11/30/1994

-4.9%

-4.5%

-5.5%

-6.8%

Financial Crisis11/1/2007–02/28/2009

4.5%

3.0%

-0.8%

-4.8%

Oil Price Plunge06/1/2015–02/28/2016

-0.8%

0.9%

0.0%

1.5%

15

Did the Federal Reserve Buy ETFs in 2020 to Shore up the ETF Market?

On March 23, 2020 in an effort to offer stability and improve liquidity in the corporate credit market, the US Federal Reserve (Fed) announced that it would begin purchasing individual bonds of US investment-grade-rated firms with a maturity of five years or less, as well as broad corporate bond ETFs. Bond and ETF shares were purchased under the Federal Reserve Secondary Market Corporate Credit Facility (SMCCF). This marked the first time in the Fed’s 107-year history that it purchased corporate bonds and the first time it purchased ETFs.

The SMCCF purchased US-listed ETFs with the investment objective of providing broad exposure to the US corporate bond market. The majority of ETFs had holdings with the primary investment objective of exposure to US investment-grade (IG) corporate bonds, and the remainder were ETFs with holdings in US high-yield (HY) corporate bonds. The Fed’s new lending programs were transformational: issuers of IG corporates, fallen angels and even HY bonds held in ETFs received implicit backing from the Fed and were able to access the capital markets at attractive funding rates.

A common misconception is that the Fed purchased the majority of HY and IG Bond ETFs that saw inflows in 2020. However, the Fed accounted for just 6.4% of the overall IG Corp and High Yield bond inflows as of June 30th, 2020. Of the 16 ETFs the Fed owned, the ratio of secondary-to-primary market activity was an average of 3:1 — meaning that for every $3 bought on the secondary market, only $1 of primary market activity resulted. In fact, on days when the Fed was buying in the secondary market, certain funds had outflows from other investor activity. Some funds traded by the Fed even had outflows on the month, underscoring the point that the Fed was not the only player — or really even a big player — in using ETFs to deploy capital.

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16

ETFs supported the Fed’s goal of injecting liquidity into the market by providing broad market access to a diverse set of firms through a single investment with trading flexibility and transparency. Notably, the Fed’s purchasing of ETFs was not seen as a way to abate any perceived stress in the fixed income ETF marketplace. If that were the Fed’s goal, the scope of its purchase would be broader. The corporate bond ETFs purchased by the Fed, as a group, make up only 19% of fixed income ETF assets.

Rather, the Fed may have appreciated certain attributes of these broad investment-grade corporate bond ETFs when deciding to include them in the SMCCF program:

• Broad ETFs own many different credits across a wide array of industries and issuers. For example, the SPDR Portfolio Intermediate Term Corporate Bond ETF (SPIB) has nearly 4,000 individual bonds in its portfolio.

• Flexible ETFs can be bought or sold on the secondary market or created/redeemed in the primary market.

• Transparent ETFs disclose their holdings on a daily basis to all investors, with any prospective changes for the indices documented in publicly disseminated rules (e.g., index methodologies).

• Stable Long-term investors use ETFs in strategic asset allocation frameworks, leading to little concern that the central bank could become a majority owner of the corporate bond ETF market.

Figure 8 High Yield and Investment-Grade Corporate Bond ETFs Flows as Part of Fed Purchase Program

Source: Bloomberg Finance, L.P., as of June 30, 2020. Past performance is not a guarantee of future results.

Fund Flow Attribution ($ Billions)

0

16

14

12

10

8

6

4

20.9

13.914.8

Estiamted Fed Fund Flows All Other Investor Fund Flows Total

17

Are There Too Many Bonds to Make Fixed Income Index Investing Efficient?

An index investment manager’s objective is to seek to track an index’s return with minimal tracking error. The objective is not to hold every bond in the index.

Generally, it is not possible to hold every bond in an index, given the sheer number of bonds. As an example, the Bloomberg Barclays US Aggregate Index contains 11,780 different bonds.* That total includes:

• US Treasury bonds

• Bonds from government-related agencies, such as the Tennessee Valley Authority

• Bonds from US corporate issuers

• Securitized bonds

• USD-denominated bonds from foreign issuers

Given the diverse holdings, portfolio managers attempt to replicate the risk characteristics of the index through sampling, rather than by holding every security. This means replicating the duration, curve, and issuer credit exposure of the index. Sampling can be the most efficient technique for constructing portfolios, as many broad fixed income indices include a large number of securities, but not all of those securities can be purchased. Coupled with potentially high transaction costs to access illiquid bonds, full replication isn’t always possible or practical. With a sampling approach, a PM can seek to build a portfolio with the same characteristics as the index.

At a high level, PMs usually take one of two approaches to ensure that tracking error remains tight and performance deviations are minimal as a result of exposure differences: top-down or bottom-up.

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Top-Down Approach

Bottom-Up Approach

This approach seeks to align the common factors of the ETF to the index, as these are the key variables that drive market beta. These factors include: Duration Considering how to match on key rate duration exposures. Credit Spread Examining differences between option-adjusted spread, as well as other metrics, such as option-adjusted spread duration. Sector Exposures Looking at the sector and industry compositions to manage macro impacts. Ratings Allocating at the credit rating level.

The bottom-up approach is often used in markets such as high yield or convertible bonds, where PMs typically find more price volatility. In a bottom-up approach, a PM tries to identify large or outsized idiosyncratic risks and mitigate them. An example of this is making the decision to purchase one bond instead of another from a company based on its position in the credit curve, a factor that can impact single bond volatility. As an illustration, we can consider the characteristics of a representative SPDR ETF tracking the Bloomberg Barclays US Aggregate Bond Index. As shown below, while the fund may only hold 5,708 out of nearly 11,780 issues in the index, the underlying portfolio closely matches on other characteristics, such as yield, coupon, maturity, option-adjusted spread, spread duration, key rate durations and average credit rating.

Figure 9 Characteristics of a Representative SPDR ETF Tracking the US Aggregate Bond Index

SPAB Portfolio The Agg +/-

Coupon (%) 3.00 3.04 0.0

Local Yield to Worst (%) 0.97 1.02 -0.1

Option Adjusted Spread (Basis Points)

54.57 58.98 -4.4

Option Adjusted Duration (Yrs) 5.95 5.94 0.0

Option Adjusted Spread Duration (Yrs) 6.36 6.35 0.0

Avg Maturity (Yrs) 8.16 8.17 0.0

Avg Credit Rating AA AA —

Key Rate Duration 6M 0.05 0.05 0.0

Key Rate Duration 2Y 0.30 0.28 0.0







Source: State Street Global Advisors, Bloomberg Finance L.P., as of July 31, 2020. The above example is for illustrative purposes only.

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Are Fixed Income ETFs Difficult to Trade?

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Complexity varies depending on the needs of the investor, but there are a few straightforward ways to trade fixed income ETFs.

Investors seeking to trade fixed income ETFs have two primary avenues:

Exchange Liquidity Requires access to a front-end trading platform and brokerage or custodial account. The investor would also need a Depository Trust Company (DTC) number if self-clearing.

Off-Exchange/Over-the-Counter (OTC) Liquidity Requires establishing trading relationships with a broker dealer and/or market maker and account settlement instructions to be able to book and settle individual trades.

When considering whether to trade on exchange or OTC, it's important to consider trade size. As you would expect, similar to single stock equities, larger trades that exceed average daily volume should be handled with greater care by working with a broker dealer or market maker OTC.

Generally, if the trade size is typical in the underlying market, it should be acceptable in the ETF. Capital markets teams can serve as a valuable resource for guidance on liquidity. These professionals are in tune with the markets and have robust relationships with liquidity providers. Capital markets teams can opine on optimal trading strategies depending on the ETF, the underlying market, the trade's size and, most important, the priorities of the executing trader.

Some investors may wish to understand the components that are used to price an ETF, such as principal, interest, cash, and accrued interest/undistributed income. This information is used in NAV construction and is factored into the costs that a broker must bear creating/redeeming ETF shares, which, in turn, are embedded into the prices at which they are willing to buy and sell ETF shares.

ETF issuers publish daily reports that include all of these components, such that any investor is able to price the ETF. Nonetheless, pricing remains dynamic, as it is dependent on factors like time of trade (it is generally better to trade when the underlying market is liquid and the creation/redemption window is open); hedging costs; and dealer balance sheet charges. And of course, pricing is dynamic because bid/offer can vary with trade size.


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A Leader in Fixed Income Investing

The Scale to Specialize:

• State Street Global Advisors’ global scale enables our portfolio managers, traders and investment strategists to be sector specialists and based in their geographic markets

• Our dedicated capital markets teams provide 24-hour coverage across global markets, offering enhanced liquidity and cost-efficient trading strategies

• Entrusted with $474 billion in fixed income assets, managing 30+ currencies across 40 different countries*

Proven Track Record:

• 24 years of bond investing — our first fixed income index fund launched in 1996

• Manage more than 100 fixed income strategies, providing choice for investors

• More than 100 fixed income professionals dedicated to conducting research, managing risks and costs, and supporting our clients

Innovative Solutions for Bond Investors:

• Comprehensive range of cost-effective ETFs

• Leveraging strategic partnerships to complement beta range, enabling investors to enhance their portfolios

* Source: State Street Global Advisors, as of June 30, 2020.

Endnotes 1 Source: Morningstar as of 06/30/2020.

2 Source: Bloomberg Finance, L.P., as of 03/31/2020.

3 Source: Bloomberg Finance, L.P., Period: 02/24/2020– 03/31/2020.

4 Source: SSGA, Bloomberg Finance, L.P., Period: 04/01/2020–07/31/2020.

5 Source: Bloomberg Finance, L.P., as of 07/31/2020.

ssga.com/etfs Glossary

Basis Point (bps) A unit of measure for interest rates, investment performance, pricing of investment services and other percentages in finance. One basis point is equal to one-hundredth of 1 percent, or 0.01%.

Bloomberg Barclays U.S. Aggregate Bond Index (the Agg) A benchmark that provides a measure of the performance of the US dollar denominated investment grade bond market, which includes investment grade government bonds, investment grade corporate bonds, mortgage pass through securities, commercial mortgage backed securities and asset backed securities that are publicly for sale in the US.

Bloomberg Barclays U.S. 1–3 Year Corporate Bond Index A benchmark designed to measure the performance of the short-term U.S. corporate bond market. It includes publicly issued US dollar-denominated and investment-grade corporate issues that have a remaining maturity of greater than or equal to one year and less than three years.

Convertible A convertible security is a security which may be exchanged for another asset, generally a fixed number of shares of common stock.

Credit Derivative Swap Contract between two counterparties where the buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults or experiences a similar credit event.

Depository Trust Company (DTC) One of the world's largest securities depositories. It also acts as a clearinghouse to process and settle trades in corporate and municipal securities.

Diversification A strategy of combining a broad mix of investments and asset class to potentially limit risk, although diversification does not guarantee protecting against a loss in falling markets.

Duration A commonly used measure, expressed in years, that measures the sensitivity of the price of a bond or a fixed-income portfolio to changes in interest rates or interest-rate expectations. The greater the duration, the greater the sensitivity to interest rates changes, and vice versa.

Liquidity The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price. Liquidity is characterized by a high level of trading activity.

Net Asset Value (NAV) The calculated assets minus liabilities divided by shares outstanding. NAV is the straightforward account of the actual assets in the fund.

Over-The-Counter, or OTC A term in financial markets used to describe transactions that occur away from any listed exchanges between individuals or involving dealer networks, whether in stock, bond, currency or derivatives markets.

Premium and Discount If an ETF is trading above its NAV, the ETF is said to be trading at a premium. If the price of the ETF is trading below its NAV, the ETF is said to be trading at a discount.

Senior Loans Floating-rate debt issued by corporations and backed by collateral such as real estate or other assets.

Total Return Swap An agreement where one party makes payments based on a set rate, while the other party makes payments based on the return of an underlying asset. In total return swaps, the underlying asset is usually an equity index, loans, or bond.

Tracking Error A measure of how consistent a portfolio’s return is with that of its benchmark. In reality, no indexing strategy can perfectly match the performance of the index or benchmark, and the tracking error quantifies the degree to which the strategy differed from the index or benchmark, by measuring the standard deviation between the two values, annualized.

Volatility The tendency of a market index or security to jump around in price. In modern portfolio theory, securities with higher volatility are generally seen as riskier due to higher potential losses.

Yield The income produced by an investment, typically calculated as the interest received annually divided by the investment’s price.Important Information Risk Disclosures

Investing involves risk including the risk of loss of principal.

Diversification does not ensure a profit or guarantee against loss.

The views expressed in this material are the views of SPDR Americas Research through the period ended July 31st, 2020 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

Passively managed funds invest by sampling the index, holding a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index.

Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates rise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

ETFs trade like stocks, are subject to investment risk and will fluctuate in market value. The investment return and principal value of an investment will fluctuate in value, so that when shares are sold or redeemed, they may be worth more or less than when they were purchased. Although shares may be bought or sold on an exchange through any brokerage account, shares are not individually redeemable from the fund. Investors may acquire shares and tender them for redemption through the fund in large aggregations known as “creation units.”Brokerage commissions and ETF expenses will reduce returns.

The trademarks and service marks referenced herein are the property of their respective owners.

Third party data providers make no warranties or representations of any kind relating to theaccuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.

The commentary does not take into account any investor’s or potential investor’s particularinvestment objectives, strategies, tax status, risk appetite or investment horizon. If you

require investment advice you should consult your tax and financial or other professional advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.

The whole or any part of this work may not be reproduced, copied or transmitted or any of itscontents disclosed to third parties without SSGA’s express written consent. Standard & Poor’s®, S&P® and SPDR® are registered trademarks of Standard and Poor’s Financial Services LLC (S&P); Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC (Dow Jones); and these trademarks have been licensed for use by S&P Dow Jones Indices LLC (SPDJI) andsublicensed for certain purposes by State Street Corporation. State Street Corporation’s financial products are not sponsored, endorsed, sold or prompted by SPDJI, Dow Jones, S&P, their respective affiliates and third party licensors and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability in relation thereto, includingfor any errors, omissions, or interruptions of any index.

BLOOMBERG®, a trademark and service mark of Bloomberg Finance L.P. and its affiliates, andBARCLAYS®, a trademark and service mark of Barclays Bank Plc.

State Street Global Advisors Funds Distributors LLC. Member FINRA SIPC.

Before investing, consider the funds’ investment objectives, risks, charges and expenses. To obtain a prospectus or summary prospectus which contains this and other information, call 1-866-787-2257 or visit spdrs.com. Read it carefully. State Street Global AdvisorsOne Iron StreetBoston, MA 02210.

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