Recognising the potential liquidity constraints involved in trading bonds, and as the fixed-income ETF market has grown in size, issuers have adapted their procedures for creating and redeeming fund units.
Last year we described how the creation and redemption process for any ETF investing in a less liquid area of the market may involve an exchange of “baskets” of securities quite different from the index being tracked, as the ETF’s managers use creations and redemptions as a way of rebalancing the fund’s portfolio.
Such baskets may even be as small as a few bonds each in a fund tracking an index with hundreds of constituents.
Creation and redemption baskets may also vary regularly in make-up, even changing intraday.
iShares explained to IndexUniverse.eu that in certain fixed income funds its creation and redemption baskets are valid only up to a maximum transaction size, after which it reserves the right to “refresh” the basket constituents.
This, said one market maker, makes it harder for dealers to quote tight secondary market prices in the ETFs concerned.
“Because the redemption basket we are given by the ETF issuer may be valid only up to a fixed dollar amount, after which the issuer may change the basket’s components, we face uncertainty quoting for a bond ETF transaction in a larger size,” Bluefin’s Laurent Kssis told IndexUniverse.eu.
“That’s because we don’t know what bonds we’re going to receive and how easy it will be to sell or hedge them. We can’t source liquidity in some of the bonds and as a market maker we therefore run a risk. When markets get volatile these are tricky products to trade.”
There is often an element of negotiation in the primary market interaction between ETF issuer and authorised participant, demonstrating a lack of standardisation in the creation and redemption process.
One ETF trader, speaking on condition of anonymity, told IndexUniverse.eu that “if we get a redemption basket and there are a couple of bonds we don’t like, we can start a negotiation process [with the issuer] and maybe get them to replace them with something else.”
But, in extremis, bond market traders requesting an ETF redemption have to accept the securities they are given by the issuer in return, removing the possibility of negotiation. Both iShares and State Street told IndexUniverse.eu that their portfolio managers have the ultimate say on what goes into creation and redemption baskets.
According to some observers, forcing APs to accept the less liquid “tail” of the bond portfolio in redemptions could accelerate market sell-offs, possibly even leading to a downward price spiral if APs feel forced to use the ETF itself to hedge losing and illiquid bond positions.
iShares stressed to IndexUniverse.eu that, despite the apparent lack of standardised procedures in the bond ETF primary market, a central principle remains.
“In-kind creation/redemption is designed to be a fair process, whereby creation/redemption baskets should be representative of risk characteristics of the fund,” the firm’s Clemons told IndexUniverse.eu.
One trader, who declined to be named, took a phlegmatic view, arguing that recent bond market volatility should serve as a healthy warning to ETF investors.
“From time to time we get a reminder that an ETF is only as liquid as its underlying asset class. This is not rocket science,” he said.