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Exchange-traded funds linked to the bond market have dominated Canadian fund flows this year, a rare occurrence in an environment when stocks are on the rise.

Canadian investors have plowed a record $12.6-billion into bond ETFs this year to date, accounting for more than half of all ETF net sales.

The spike in popularity partly reflects an overall demand for safety amid global recession worries, despite a recent rally in Canadian stocks to record highs.

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But this year’s bond ETF buying frenzy has a deeper, more lasting catalyst, as investors around the world increasingly replace physical bonds with liquid ETF products, said Daniel Straus, head of ETF research at National Bank Financial.

“Fixed income has a rising tide because there's a general widespread adoption that's still taking place, people are moving from bonds into ETFs,” Mr. Straus said.

That rising tide has also raised questions about potential unintended consequences of the ETF boom.

Back in September, celebrity investor Michael Burry, whose fortunes made in the subprime mortgage crisis were featured in Michael Lewis’s The Big Short, warned of an ETF bubble.

ETF alarmists have long argued that the trillions of dollars flowing into passive funds could distort asset prices and lead to a crash.

“All this gets worse as you get into even less liquid equity and bond markets globally,” Mr. Burry told Bloomberg News.

ETFs are often lauded by their advocates for having “democratized” investing for the masses, for opening up once-inaccessible markets with a low-cost, easily tradable vehicle.

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Nowhere has the transformation been more apparent than in the bond market.

Any Canadian investor can access hundreds of bond issues through a single ticker for a management fee of less than 0.1 per cent.

“The biggest advantage is having the opportunity to buy the whole market, and not to have to worry too much about credit risk,” said Raymond Kerzérho, director of research at PWL Capital.

Institutional investors, meanwhile, are increasingly turning to bond ETFs as tools in fixed-income strategies.

As markets have evolved and digitized, the physical bond market has generally remained low-tech and illiquid.

“Bonds themselves still come from this kind of Jurassic age of securities trading. A lot of it is done over the phone,” Mr. Straus said.

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That structural component of institutional demand likely ensures relatively persistent growth for bond ETFs, regardless of market conditions, he said.

And the bond ETF space has plenty of catching up to do compared with the equity side.

In the second quarter, assets under management in bond ETFs globally hit US$1-trillion for the first time, while stock ETFs commanded US$4.3-trillion as of the end of June, according to Morningstar data.

Canadian fixed-income ETFs have $68.5-billion in assets, representing about one-third of the domestic ETF market, according to National Bank data. There is still plenty of room to grow, Mr. Straus said.

Doubts persist, however, as ETFs continue to reshape the way people invest. With bond ETFs in particular, the most common risk cited relates to liquidity.

Bond ETFs act like stocks, with the largest ones trading many thousands of times a day, while even the most liquid bonds are limited to three or four daily trades.

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That means an ETF can reflect price swings not yet incorporated into the underlying securities.

“A prolonged financial stress could result in persistent price differentials between ETFs and their underlying assets,” TD economists wrote in a report last year.

“In its extreme, this could undermine investors' confidence and result in a contagion to other financial asset classes.”

And yet, the vast majority of ETF trading occurs in the secondary market – a transfer of ETF shares from one investor to another, with no trading of the underlying securities involved.

In times of heightened market volatility, that added liquidity acts as a “release valve,” said Robert Duncan, a portfolio manager at Forstrong Global Asset Management.

“In 2008, nobody could trade high-yield bonds, but high-yield ETFs were trading hundreds of millions of dollars a day.”

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