The barbell tolls for fixed income investing

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The author is vice-chair at Oliver Wyman and former global head of banks and diversified financials research at Morgan Stanley

A trio of recent records tells us something important about capital markets: that the “barbell effect” long associated with equity investing is now playing out in the bond markets in earnest. This shift underscores just how much the market structure of finance is changing.

Investors have poured nearly $190bn into US fixed income exchange traded funds this year to August according to Morningstar, 50 per cent higher than this time last year. Last month Ares raised the largest private credit fund in history at $34bn. And 13 major banks have formed partnerships with private credit firms to distribute their loans in the last year — up from two the year before.

My guiding view has been that investor flows would polarise into a barbell. At one end, investors would flock to passive funds and exchange traded funds to access benchmark returns cheaply and conveniently. At the other, investors seeking higher returns would increasingly allocate funds to specialist managers investing in private equity, hedge funds and the like.

The conventional “core” traditional active managers, caught in the middle, would be pressured to tune up their investment engines, become more specialised, or merge for scale, as I argued twenty years ago in a Morgan Stanley research note.

The barbell has tolled. At one end ETFs have grown from $200mn in 2003 to $14.0tn at the end of August, according to ETFGI. At the other, over half of all the management fees in the investment industry will go to alternative asset managers in 2024, up from 28 per cent in 2003, according to Morgan Stanley and Oliver Wyman estimates.

The barbell effect is now reshaping bond investing. First, there is a sea change in allocations to credit after 15 years of zero or negative rates. Investors are fundamentally rethinking the composition of their portfolios. Since the Fed started raising rates, the share of US bond funds managed in ETF format has surged from 21 to 28 per cent, according to Morningstar data.  

Investors are demanding more for far less. Active bond ETFs have a median net expense ratio of 0.40 per cent, undercutting 0.65 per cent of bond mutual funds, according to State Street Global Investors. At the other end of the industry, leading alternative firms are pulling ahead, despite the indigestion in private markets. The top six listed alternative players saw a whopping 21 per cent net new money poured into their credit strategies in the year to June 2024 compared with just 1 per cent for all traditional firms.   

Second, public bond markets are becoming increasingly automated which is enabling specialist slices of risk or blends to be packaged into bond ETFs.

Third, banks around the world are under pressure from a range of new regulations such as new capital requirements, driving another wave of disintermediation. What we are seeing is the slicing up of risk in the banking system, where banks parcel the riskiest portions of debt and pass this on to private credit funds, retaining less risky parts of the lending themselves. As new bank rules become clearer, teams adjust. The flurry of partnerships and risk transfer deals in recent months is now likely to accelerate.

Fourth, private credit players are seeking to reduce their cost of capital to enable them to be relevant for even more higher quality, investment grade assets on banks’ balance sheets. Leading firms, taking their cue from Apollo Global, are becoming major providers to the insurance industry.

Together, these forces will have a huge impact on the structure of financing markets and banks, and on how bonds are traded. For instance, ETFs are ever more becoming the primary source of bond liquidity.

For traditional asset managers, the pressure to adapt has never been more acute. For some, the struggle to maintain margins and assets will drive intense cost cutting and more consolidation to increase scale. Many more deals are likely.

It is also prompting a Cambrian explosion of innovation. The tie up between KKR and Capital Group to create one of the first public-private fixed income funds, and the partnership between Blackrock and Partners Group to create blended private markets portfolios, are critical to watch. As is the intriguing agreement between Apollo and State Street Global Investors to create a hybrid ETF fund to invest in both public and private credit. These mark significant bets on the mainstreaming of private credit.  

No trend goes unchecked, and there will be bumps along the road, not least from the credit cycle. But if the barbell becomes as big a force in bonds as it has in equities, there is huge change ahead.