A version of this article was originally published in the Financial Times.

Record inflows into fixed income exchange traded-funds (ETFs) and leading private credit funds signal a transformation in bond markets, reshaping the future of finance.

Investors continue to allocate to credit products — but the shape of the new inflows is changing. The “barbell effect” associated with equity investing is now playing out in the bond markets, reshaping the structure of financing markets, banks and how bonds are traded. On one end of the barbell, investors have poured $187 billion into US fixed income ETFs (50% higher than last year). At the other end, our new estimates suggest that the top six listed alternative asset managers say 21% net new money (NNM) into their credit strategies in the 12 months to June 2024, versus 1% for traditional firms. We explore how this shift is playing out in bond markets — and how market players are responding.

Barbell effect shifts bond market dynamics

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. Last month Ares raised the largest private credit fund in history at $34 billion. And 12 major banks have formed partnerships with private credit firms to distribute their loans in the last year — six times the year before.

My guiding view has been that investor flows would polarize into a barbell.  At one end, investors would flock to passive funds and EFTs to access benchmark returns cheaply and conveniently. At the other, investors seeking higher returns would increasingly allocate to specialist fund 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 specialized, or merge for scale, I argued 20 years ago in a Morgan Stanley research note.

The barbell effect is now reshaping bond investing

The barbell has tolled. At one end ETFs have grown from $0.2 trillion in 2003 to $14.0 trillion 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% in 2003 according to our estimates and those of Morgan Stanley.

Shifting credit allocations

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 and recalibrating risk budgets. Assets are in motion with many wanting low-cost building blocks at one end. Since the Fed started raising rates, the share of US bond funds managed in ETF format has surged from 21% to 28%, according to Morningstar data. 

Investors are demanding more for far less. Active bond ETFs have a median net expense ratio of 0.40% under cutting bond mutual fund at 0.65%, according to State Street Global Investors. At the other end, leading alternative firms are pulling ahead, despite the indigestion in private markets. 

Alternative firms leading the way

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

Automation in bond markets

Banks around the world are under pressure to diet into a range of new regulations, driving another wave of disintermediation. What we are seeing is the re-tranching of the banking system where banks parcel the riskiest slice to private credit, providing less risky lending themselves. As new bank rules become clearer, teams adjust. Hence the flurry of partnerships and risk transfer deals in recent months is likely to accelerate.

Regulatory pressures on banks

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.

Impact of ETFs and regulatory adaptation on financing markets

Together, these will have huge impact on the structure of financing markets, banks, and how bonds are traded. For instance, ETFs are ever more becoming the primary source of bond liquidity. Regulators too will need to expand their toolkit to keep a keen finger on the credit pulse of the economy. 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 drive scale. Many more deals are likely. It is also prompting a Cambrian explosion of innovation. At one end, a range of marquee firms have recognized they need to offer bond funds in ETF format to be competitive.   

Innovation and hybrid bond funds in the evolving bond market

 At the other, there is acute interest in forging a new category of hybrid bond funds which can go on and off-piste. The tie ups between KKR and Capital International to create the first public-private fixed income fund, and the partnership between Blackrock and Partners Group to create a blended private markets fund, are critical to watch. As is the intriguing agreement between Apollo and State Street Global Investors to create a hybrid ETF fund with up to 15% 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.

Read the original piece here.