Are Bond ETFs More Liquid Than Bonds?

Bond ETF Liquidity Dictated By More Than Bonds

The bond market is more illiquid than the stock market. There's no single, official exchange where bonds can be bought and sold, and many bonds trade infrequently. Some go days, weeks, even months without trading. What's more, new regulations introduced in the wake of the 2008-09 financial crisis have dried up bond market liquidity even further, making it harder for banks to maintain deep inventories and retain talent.

But bond ETF liquidity isn't wholly dictated by the underlying bond market. Remember: A bond ETF's liquidity is a function of both how it trades in the secondary market and how easily APs can create and redeem ETF shares. The liquidity of the bond market—that is, the ETF's primary liquidityis only part of the puzzle.

In fact, because bond ETFs are so liquid, they can sometimes circumvent illiquidity in their underlying bonds. Consider muni bonds, which don't trade very frequently, or sovereign debt in countries whose market hours don't overlap with ours. Bond ETFs featuring these securities will trade even when their underlying bonds won't. In fact, research by BlackRock shows that bond ETFs trade, on average, four to five times more frequently than the underlying bond market.

Primary liquidity is still important, however. It's tempting to think that the liquidity of the underlying bonds doesn't matter to ETF investors. But that's not true. Primary liquidity, for example, influences the premiums and discounts that an ETF develops:

  • For an ETF with low trading volume but a highly liquid portfolio of bonds, it may be almost impossible for a retail investor to trade 1,000 ETF shares. But if the underlying securities are liquid, an AP can create/redeem a creation unit of 50,000 shares, no sweat.
  • For an ETF with high trading volume but a highly illiquid portfolio of bonds, it may be very easy for a retail investor to trade 1,000 shares, but an AP may find it incredibly difficultand expensiveto amass enough underlying bonds for a creation unit.
  • When it's hard for an AP to buy up underlying bonds, they're more likely to let the ETF trade at a premium to its market price before making new shares.
  • Likewise, when investors want out, an AP will also let the ETF trade at a discount to NAV before buying up the ETF shares to redeem if those underlying bonds are illiqiuid.

Though most retail investors can focus on secondary, "on screen" liquidity, the liquidity of the underlying market is always important.
 

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