Given how liquidity in the bond market has dried up, many investors understandably have begun to worry about the liquidity risk of ETFs based on those bonds.
Some critics argue that if interest rates rise and spark a mass market exodus, bond ETF investors are the ones who'll get burned the worst. Others claim those fears are entirely overblown, and that in a panic, bond ETFs are the safest place to be. The truth is somewhere in the middle.
It comes back to how ETF liquidity works.
How ETF Liquidity Works
ETFs have two kinds of liquidity: primary and secondary. Primary liquidity is the liquidity of the primary market for the ETF, while secondary liquidity is the liquidity of its secondary market. Each has its own nuances. Let's start with the latter.
- Secondary liquidity is "on screen" liquidity. Most retail investors buy and sell ETFs in the secondary market; that is, when you buy an ETF by entering a buy order into your brokerage account, you're investing in the secondary market. You trade with another investor or with a market maker using ETF shares that already exist. This secondary liquidity can be evaluated by looking at average volume and spreads, as well as premiums and discounts to net asset value (NAV).
- Primary liquidity is how easy it is to create or redeem ETF shares. The supply of ETF shares is flexible. Special institutional investors called "authorized participants" (APs) can create or redeem ETF shares to offset demand. To create new ETF shares, an AP submits a large basket of the underlying securities—a creation unit—to the fund issuers, who give an equally valued basket of ETF shares in return. To redeem old ETF shares, an AP submits a creation unit's worth of ETF shares, and receives an equally valued basket of the underlying securities. Primary liquidity, therefore, deals with how liquid the underlying securities that an ETF holds are. This liquidity dictates how efficiently APs can perform their job.
Primary liquidity doesn't solely dictate secondary liquidity, and vice versa. In the secondary market, liquidity is determined largely by the trading value of the ETF shares. In the primary market, however, liquidity is determined more by the value of the ETF's underlying securities, since APs and issuers use those to create and redeem ETF shares.
So what does this have to do with bond ETFs? Everything.
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 liquidity—is only part of the puzzle.
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 difficult—and expensive—to 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.
What Happens To Bond ETF Liquidity If Rates Rise?
What happens if interest rates rise and liquidity dries up from the underlying bond market altogether? Will investors lose their shirts on mispriced ETFs and enormous discounts to NAV?
For starters, a bond ETF's price, even at a discount to NAV, may actually be a better measure of the fair value of its portfolio than the prices of its underlying bonds:
- Individual bond values are hard to calculate. Without an official exchange, there's no single agreed-upon price for the value of any particular bond.
- Fund managers need accurate bond prices to calculate NAV. They rely on bond pricing services, which estimate the value of individual bonds based on reported trades, trading desk surveys, matrix models and so on.
- In stressed markets, an ETF's price may fall below its reported NAV. When that happens, it essentially means the APs think the bond pricing service is wrong; bond price estimates sometimes lag major moves in the market, after all. In other words, the APs don't believe they can actually liquidate the underlying bonds for their reported values.
- Large premiums and discounts don't necessarily signal mispricing in a bond ETF. Instead, the ETF may be performing price discovery for the value of its underlying bonds. This is more likely the case if the ETF has high secondary liquidity, meaning its shares trade regularly, and with high volume.
Secondly, if a bond panic does occur, investors who buy and hold a bond ETF are safer than those who buy and hold a bond mutual fund.
- Bond mutual funds do buy and sell exactly at NAV in times of market stress. Trading exactly at NAV shields shareholders who want to exit during times of market stress from the true costs of liquidating that portfolio. But what about the shareholders who don't sell?
- It's tough to fulfill redemption requests during a bond panic. To fill a redemption request, mutual fund managers must give exiting investors cash equal in value to NAV. In normal markets, managers would just sell bonds, but in stressed markets, that's not as easy to do. After all, APs have proven that it's not possible to sell the underlying bonds for the prices given by the bond pricing service. So mutual funds often have to sell more bonds than the NAV's worth to make up the difference.
- Buy-and-hold bond mutual fund investors subsidize the costs of investors who flee. Someone has to absorb that cost. Plus, because funds process redemptions overnight, they must keep cash on hand—creating cash drag on returns—or maintain a credit facility, which shows up as a fund expense. As a result, buy-and-hold bond mutual fund investors are often penalized for staying in their fund during periods of market stress.
Next: How Do Bond ETFs Work?
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