Asian institutions are showing increasing appetite for fixed income exchange-traded funds (ETFs), even though overall investor understanding of ETFs remains low.

Underpinning the ETF demand is a huge increase in Asian corporate bond issuance, Marco Montanari, Deutsche Asset Management’s head of passive asset management for Asia Pacific, said at the Inside ETFs Asia event, produced in association with AsianInvestor, on November 8 in Hong Kong.

However, Asia still lags Europe and the US when it comes to usage of fixed income ETFs, he noted.

“Among ETFs listed in Asia, 90% are equity-based while 10% is fixed income,” he pointed out. In contrast, in Europe and the US, fixed income ETFs account for around 25% of the overall ETF market, Montanari added.

Assets under management in Asian fixed income ETFs grew by around 50% from May 2015 to May 2017, outpacing all other categories of ETF, including equity and commodities, in Asia, North America, and Europe, a May report by financial services firm IHS Markit showed.

Dollar-denominated debt issuance (sovereign and corporate) in Asia hit a multi-year high of $267 billion between January 1 and October 31, 2017, according to a Citi debt origination report dated November 10.

Challenges abound

The main obstacle to greater ETF adoption has been a lack of education, said Montanari, adding that bond ETFs in Asia introduce more pricing transparency and liquidity in a regional bond market that has typically been viewed as shallow.

However, understanding the liquidity that ETFs bring to this market requires going beyond looking at trading turnover of ETFs on the exchanges.

Trading turnover on exchanges only show the “visible” volumes, according to industry experts who say that what really needs to be assessed is the liquidity of the underlying portfolio of securities.

Unlike traditional shares or bonds, the supply of ETFs is not fixed: market makers can create more units (issued by the ETF issuer) to meet demand and can also redeem units should supply exceed demand.

“Asian investors need to become more comfortable about trading an ETF that doesn’t have large volumes on the exchange,” Montanari said.

Scepticism around passive fixed income opportunities is also more pronounced in Asia compared to the US and Europe, said Matthew Arnold, head of SPDR ETFs for SIngapore and head of ETF strategy and research for Asia Pacific at State Street Global Advisors.

“The lower level of adoption of passives in the region is likely due, at least in part, to the fund distribution model in the region,” Arnold told AsianInvestor, noting that advisors in large fund markets in Singapore and Hong Kong are often better compensated for selling actively managed funds compared to passively managed index funds and ETFs.

Montanari also noted that investors who rely on popular indices like the iBoxx USD Investment Grade Index may miss out on the best opportunities in the Asian corporate bond space.

The iBoxx index excludes non-developed markets, including China, India, Malaysia, and Indonesia—all markets that have relatively higher yielding opportunties, he noted.

China's ETF potential

Within Asia, China is being viewed as a high potential market for ETFs, especially as investors gear up for the inclusion of Chinese bonds in major bond indices.

Montanari expects more than $250 billion to flow into Chinese bonds over the next five years. This could lead to a lot of growth in the Chinese bond ETF market, said Montanari. “There are no large China bond ETFs right now but that will change,” he said.

He expects to see more Chinese bond ETFs with several billion of US dollars of assets under management in coming years.

China’s onshore bond market, currently the third largest in the world with $6.6 trillion in assets, is expected to almost double by 2020, a March report by asset manager OppenheimerFunds said.

Nevertheless, Montanari acknowledged that investors remain wary of Asian corporate bonds, in particular those issued by Chinese companies. Foreign investors are worried about the headlines around high levels of Chinese debt, he said, noting that exposure to Chinese companies remains a concern.

However, since most corporate bond issuers are state-owned enterprises, investors can manage their risk if they focus on investment grade companies, Montanari added.