The past few weeks, much has been said about our prediction that the fixed income ETF market could grow to $2 trillion in the next 10 years.  It’s a mammoth number, to be sure, but one we believe is not only possible, but probable – for a variety of reasons.

First, how did we get to the massive $2 trillion figure?  My colleague and fellow iShares blogger Matt Tucker did some analysis and found that, as of the end of last year, bond ETFs represented only 0.3% of global fixed income (“FI”) assets, as compared with equity ETFs which made up about 2.2% of global equity assets.  If the US FI ETF market were to reach the same level of penetration reached by equities, they would go from $222 billion to over $1.4 trillion.  Add in global FI ETF growth, and $2 trillion is actually a conservative estimate.

In addition, fixed income products now account for 18% of global ETP assets, up from 7% in 2007 at the onset of the financial crisis.  Bond ETPs are driving industry flows more now than ever before, garnering a 40% share in the first half of 2012.  If flows were to continue on their current trajectory, it would also support the $2 trillion forecast.

So we think the growth in FI ETFs will be substantial, but do we have any idea what areas of the market will see the biggest flows?  While we don’t have a crystal ball, we think there’s a compelling growth opportunity in segments where purchasing bonds on the secondary market is more challenging due to pricing opacity and liquidity limitations – places like investment grade corporates, municipals, and the high yield bond sector.  Recent ETP growth rates have been quite strong in corporates and high yield, but flows still don’t come close to the penetration already seen by mutual funds in these areas (see below). For example, ETP flows in the underlying $7 trillion US investment grade corporate segment have shown consistent strength over the last two years, yet ETPs only account for 0.5% of assets in contrast to 17% for mutual funds.  This sector offers tremendous potential in a low yield environment, as investors seeking income are embracing the category which has the potential to offer yields above the rate of inflation.  ETPs have made greater headway into the smaller US high yield bond market, but have still experienced much smaller penetration than their mutual fund counterparts (2.3% vs. 22.2%).

As for the muni market, ETPs have been slow to gain traction.  However, we believe this $3.7 trillion segment should provide future growth opportunities as investors come to realize the benefits ETPs can offer in this space.  In addition to the above-listed benefits of fixed income ETFs, muni ETFs can help investors address liquidity and sourcing issues often experienced when trying to trade individual municipal securities.

But setting aside the numbers for a moment, there are several less tangible factors that have been contributing and should continue to contribute to the success of the fixed income ETF market overall.  We’ve said it before, and we’ll say it again – these products have revolutionized the FI market.  Ten years ago, prior to the launch of the first bond ETF, investing in fixed income was a much different experience.  With the advent of bond ETFs, every investor suddenly had access to relatively low cost, transparent, diversified baskets of bonds that benefit from the flexibility of trading on the equity exchange.

As the bond ETF evolution continues, the bottom line is that this phenomenon has become too big for investors to ignore.  And why would anyone want to ignore it?  Fixed income ETFs may be the future of investing in the FI space.

Sources: BlackRock Investment Institute, Bloomberg, Securities Industry and Financial Markets Association (SIFMA), Strategic Insight Simfund

Bonds and bond funds will decrease in value as interest rates rise. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity. . A portion of a municipal bond fund’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax.

Buying and selling shares of iShares Funds will result in brokerage commissions. Diversification may not protect against market risk.