Lost in all the market volatility and concerns about interest rate hikes and inflation was a regulatory ruling with major implications for asset capture in the ETF industry. The New York State Department of Financial Services is the state’s insurance regulator.  In December it published a new regulation that, until Jan. 1, 2027, allows shares of an ETF to be treated as bonds for the purpose of a domestic insurer’s risk-based capital report provided the ETF meets certain criteria. The two most pertinent criteria are that the ETF tracks a bond index and has at least $1 billion in assets under management. Why is this so important?  At the end of 2019, the US Insurance industry reported holding more than $4.5 trillion in bonds.  

“This puts bond ETFs on a level playing field with bonds in an insurer’s portfolio,” said Robert S, Kapito, President of BlackRock, on Jan. 14 during the company’s earnings call for the fourth quarter 2021.  He added that BlackRock is “very excited about the fact that insurers now will use more ETFs to represent their bond portfolio.”  BlackRock is the sponsor of iShares.

Photo by Ibrahim Boran on Unsplash

The difference between treating a holding as debt rather than equity for risk-based capital requirement purposes “is orders of magnitude,” said attorney Daniel A. Rabinowitz, a partner at the law firm Kramer Levin Naftalis & Frankel. He states that “You have to hold much, much more capital against equity securities.”

Among criteria an ETF must meet to qualify under the new regulation are that the fund tracks a bond index and has at least $1 billion in assets under management. A quick top-level analysis of the current array of bond ETFs offered in the US provides key insights.  The bottom line is that iShares and Vanguard will probably be the largest beneficiaries of the new rules.  A closer look reveals why. 

There are 97 Bond ETFs that currently satisfy those two criteria.  The lion’s share of the assets are accounted for by the top 25.  Those ETFs have between $10 billion and $91 billion in AUM.  The remaining 72 have less than $10 billion apiece. Of these, there are another 20 Bond ETFs with between $5 and $10 billion.  Two index providers, Bloomberg and ICE Data Services, are dominant in AUM and number of products.

Taking a deeper dive, 17 of the largest 25 ETFs are iShares.  Six are Vanguard products with one apiece issued by Schwab and SPDRs.  It surprised me that four of the top 5 in AUM were Vanguard ETFs.  It also surprised me that very close to half (47.3%) of the total AUM in the top 10 were in those Vanguard products.  Here is a table from an ETF.com screen showing the top ten ETFs of the 97 that would qualify today under the new NY State Insurance rule reducing capital requirements.

Summarizing some salient points from this table:

1. The top 10 indexed bond ETFs account for $446.5 billion or about 37% of the $1.2 trillion currently in bond ETFs.  
2. The two largest bond funds, one from iShares and the other from Vanguard, follow very similar total US bond market indexes and are almost identical in AUM Together, they comprise about $170 billion.
3. All of the Vanguard bond ETFs have iShares counterparts with only AGG being larger than the Vanguard entry.

In assessing what all this will mean for the exchanged-traded ecosystem requires two data points I do not have:

• How quickly will insurance companies take advantage of the simplified operational processes, lower trading, custody, clearing, settlement and compliance costs and greater fungibility they would realize by replacing the bonds they hold with qualifying bond ETFs?
• What percentage of  the dollar value of insurance company bond holdings that can potentially take advantage of this ruling?

From a bottom line and best practices perspective, the answer to the first question should be: ASAP.  The operational advantages and cost savings to be realized from switching qualifying bond holdings to shares of ETFs are tremendous.  Tempering this excitement is my personal experience in my profession.  In my 40 years in the investment industry, even the most obviously beneficial changes take at least months and generally years to be accepted and adopted.  It is also true that the US insurance industry’s record of implementing lightning-fast changes is less than prodigious.  Still, the cost savings on the table is huge.

The answer to the second question requires knowing whether most of the other state insurance regulators will follow suit with similar rulings so that there is national adoption of this treatment of bond ETFs regarding capital requirements.  My expectation is that the national regulatory part of the equation will be taken care of very quickly.  Once that hurdle is overcome, my best guess is that at least 75% of the fixed income assets held by US insurance companies could be converted in this manner into indexed bond ETFs.

Taken altogether the implications are huge.  As of year end, according to ETFGI, a leading provider of institutional ETF Research, there were 2628 US equity ETFs comprising $5.5 Trillion in AUM.  In contrast, the number of bond ETFs was just 496 with assets of just $1.2 trillion.  In both cases the magnitude approaches five-to-one in favor of equities.  If this conversion of assets becomes a groundswell over the next 3 years as I suspect it must, the ratio of AUM should shrink from 5:1 to about 1:1 unless other factors intervene.  When you consider that the global context is that more than 70% of capital markets assets are in fixed income securities rather than equities, this global ETF AUM shift makes sense.  

Beyond insurance companies, what are the implications?

1. Obviously, Blackrock and Vanguard will profit enormously.
2. Schwab is perfectly positioned to add significant assets to its existing few products and create more so that their customers could quickly help them meet the threshold criteria.  Looking at current customers also makes me think that FlexShares at Northern Trust could be able to take advantage of this move.
3. SSgA’s SPDR brand is the wild card here.  Fixed income ETFs have simply not been a focal point for them until now.  To what extent are they in a position to change that quickly?  It will be interesting to see.
4. Fee wars among all providers are likely in my opinion.  Most products are tightly priced in the single digits of basis points but TIPS, LQD and a few other iShares may have some wiggle room.
5. For all investors, more assets mean more liquidity in Bond ETFs.  That is a very positive and could even become a self-feeding juggernaut.  
6. Hedge Funds should find it easier to implement long-short strategies intrinsic to global macro and other arbitrage products. 
7. The three groups of products that this does not assist are active ETFs, preferred stock ETFs and equity ETFs. 
8. The expected windfall of liquidity means little for most clients of financial advisors because the combination of relatively long durations and low yields-to-maturity (YTM) compared to high durations make the two top ETFs, AGG and BND relatively unattractive now.  Long-term bond prices are expected to fall as dramatically as rates are expected to rise.  On a real-return basis, the expected rise in inflation could make long bond investments even less attractive.

On this last point, there is an ETF that Ron DeLegge, Founder of ETF Guide, just discussed on a recent podcast: PFLD as an alternative to AGG.  Upon investigation I agree it is worth a long look.  PFLD is The AAM Low Duration Preferred & Income Securities ETF.  It aims to provide higher annual income streams with lower implied interest rate risk (as measured by duration) than total bond portfolios.  During the past 12 months, in a similarly fearful environment, PFLD recorded a total return of +2.82% as compared with -3.56% for AGG.  Two bonuses are that PFLD pays monthly dividends, and its preferred stock income is classified as qualified which may be taxable at a lower rate for some investors.  One detriment is a high expense ratio of 0.45% as compared with 0.04% for AGG although in recent periods, its returns have more than compensated for its fees.  To clarify, PFLD will not benefit from the projected windfall of insurance company assets but is included as an attractive alternative to bond ETFs in the current yield, interest rate risk and inflationary environment.

In summary, it is generally not easy to predict a seismic change in the capital markets.  In this case, I am compelled to do so.  Be prepared to watch the asset growth in bond ETFs significantly outpace asset growth in equity ETFs during the next three years.