Fixed Income Exchange Traded Funds Reflecting market conditions, dampening market volatility Ed Fishwick Global Co-Head of Risk & Quantitative Analysis Paris, 21 March 2016 The opinions expressed are as of March 2016 and may change as subsequent conditions vary. for professional clients/qualified investors only

Summary Learning to live with less – liquidity in today’s bond markets The competing phenomena – less balance sheet, increased corporate bond issuance, growth of mutual funds Addressing the liquidity challenge - bond ETFs provide price discovery and incremental liquidity The rise of ETFs in context ETF trading – reflecting market reality, dampening volatility during market stress ETFs – a net positive in today’s changing market ecosystem for professional clients/qualified investors only CARS ID: EMERQA-0002

Learning to live with less – liquidity in today’s bond markets Source: New York Federal Reserve, HaverAnalytics. As of Dec. 31, Prior to April 2013, the primary dealer corporate bond positions data included non-agency RMBS and CMBS. The size of the fixed income markets have grown dramatically due to increased bond issuance. At the same time, inventory at broker-dealers has been reduced New issuance remains strong as evidenced by both record issuance and an increase in the average size of new issuance. Secondary markets are thinner (lower turnover) than pre-crisis. Primary dealer holdings US Investment Grade: Volume, Outstanding and Turnover Source: MarketAxess. As of Dec. 31, for professional clients/qualified investors only CARS ID: EMERQA-0002

The rise of ETFs in context I ETFs form a small percentage of the vast network of bond asset owners Holders of debt securities Corporates & Foreign Bonds US Treasury securities Time series of total debt ownership by asset holders in Fed Z.1 data, shows the increase in total debt outstanding Out of the $39 trillion in debt securities, ETFs and open ended mutual funds represent 13% of debt ownership Source: Fed Z.1 Data. As of 3Q15 for professional clients/qualified investors only CARS ID: EMERQA-0002

The rise of ETFs in context II Turnover of Bond ETFs Source: Bloomberg. As of Dec. 31, Daily volumes calculated using monthly data assuming 22 business days. Market share calculated using ETF volume divided by the sum of ETF Volume and Cash Bond Volume. The exhibits below compare the turnover of fixed income ETFs to trading activity in the underlying bond markets. In both graphs, the blue section reflects daily traded volumes for investment grade and high yield bond ETFs, the yellow line represents the ETF trading volume as a percentage of the sum of ETF trading volume and bond trading volume The has been a significant increase in high yield bond ETF trading as a percentage of bond exposure trading volume Growth of bond ETFs and bond ETF trading volumes need to be considered in the context of understanding the future of bond market liquidity Turnover of Investment Grade ETFs Turnover of High Yield ETFs for professional clients/qualified investors only CARS ID: EMERQA-0002

ETFs – a net positive in today’s changing market ecosystem ETFs provide price discovery and an additional source of liquidity Source: Dealer inventory data from the New York Federal Reserve as of Dec. 31, Includes Investment Grade and High Yield Corporate Bonds and Commercial Paper. Investment grade credit and high yield ETF AUM data from Bloomberg as of Dec. 31, Includes only US ETFs. ETF trading volume has repeatedly increased during periods of market stress This behaviour was observed during the 2008 Crisis, in the wake of the 2013 Taper Tantrum, in the period following and during the December 2015 sell-off in high yield bonds Looking back at the past three years, bond ETFs appear to be growing and potentially supplanting declining dealer inventories Source: Dealer inventory data from the New York Federal Reserve as of Dec. 31, Includes Investment Grade and High Yield Corporate Bonds and Commercial Paper. Investment grade credit and high yield ETF AUM data from Bloomberg as of Dec. 31, Includes only US ETFs. Daily traded volume of ETFs AUM of Bond ETFs vs dealer inventory for professional clients/qualified investors only CARS ID: EMERQA-0002

Glossary of Key Terms Authorized Participant (AP): These firms, typically large financial institutions, have an agreement with an ETF provider to create and redeem ETF shares. Creation: The issuance of a block of new ETF shares. ETF Basket: A list of securities published by an ETF that is representative of the ETF’s holdings and for which the ETF stands ready to exchange its shares in creation or redemption transactions. The contents of the basket (security names and quantities) are made public daily. ETF Creation/Redemption: The process by which ETF shares of ETFs are issued to, and redeemed from, Authorized Participants. ETF creations and redemptions are typically for very large blocks of shares and are settled by delivery of the ETF Basket (but may be settled for cash when in-kind delivery of assets is impractical, using a variety of transaction charges so that costs are borne by APs in a manner similar to an in-kind delivery). Liquidity Premium: The excess return expected to be earned on an asset at a given point in time due to its relative market liquidity. In equilibrium, the market should compensate owners of less liquid assets with a liquidity premium relative to a more liquid asset. Given the prolonged period of low interest rates, it is unclear whether liquidity premiums have been appropriately priced into asset values. Liquidity Terms of a Fund: The structural features of a fund that determine how often and under what conditions shareholders can redeem. This includes redemption frequency (e.g., daily, monthly), fund structure (e.g., open-end fund, ETF, closed-end fund, hedge fund, etc.), and redemption provisions (e.g., notice periods, ability to gate the fund, redemption fees, the ability to make redemptions in-kind). Market Liquidity: Generally refers to the degree to which an asset can be bought or sold in the market without affecting the asset’s price. The more liquid an ETF, the easier and more cost-effective it will be to trade. A lack of liquidity can translate into difficulties entering and existing trading positions, alongside higher trading costs. Premiums vs Discounts: The direction in which an ETF’s market price differs from its Net Asset Value. If the price exceeds its NAV, the ETF is trading at a premium. If the price is below the NAV, the ETF is trading at a discount. Premiums and discounts often result from stale security prices used to calculate NAVs, due to illiquid trading or time differences in markets of the underlying assets. Bond ETFs often trade at a small premium. Price Discovery: A hallmark of ETF design, which provides a mechanism for market participants to accurately price assets or markets that otherwise are not trading. The ability to arbitrage the prices of an ETF share and its underlying securities eventually helps the two prices converge by rebalancing supply and demand. An ETF’s price reflects an actionable, real-time value of the underlying assets they represent, and are increasingly preferred by investors, particularly when market sentiments shift rapidly. Redemption: The cancellation of a block of ETF shares in exchange for the ETF Basket Spread: The difference between the highest bid to purchase an asset and the lowest offer to sell an asset. Lower spreads are associated with greater liquidity brought about from more competition among buyers and sellers, and result in lower transaction costs for investors. 6 for professional clients/qualified investors only CARS ID: EMERQA-0002

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