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.