ETFs Can’t Fix Low Bond Market Liquidity

October 24, 2014

The net result is a lower proportion of outstanding bonds that are readily available to trade at primary dealers. Some panelists also lamented a drained talent pool at the primary dealers as veteran traders have moved on.

ETF Alchemy

Paradoxically, fixed-income ETFs themselves are trading quite well even if their underlying assets aren’t. Corporate bond ETFs—the popular ones anyway—tend to trade at very tight spreads. This is the alchemy: ETFs are often far cheaper to trade than it would be to trade the basket of the underlying bonds.

So why all the fuss? The worry is that liquidity for bond ETFs will greatly deteriorate in a major downturn given that the underlying markets aren’t strong.

So far that hasn’t happened, but we haven’t seen a true test either.

The Brighter Side

One panelist noted a bright spot compared with the old days of trading entire bond portfolios in panicked markets: At least with an ETF, once it’s sold, you’re completely out, rather than trying to unwind your portfolio over many days. Another panelist recognized flaws in bond liquidity, but didn’t consider that a systemic threat to bond investing.

For now, we know that healthy bond ETFs trade well in good times and reasonably well in moderately bad times. The true test of how trading holds up in a major meltdown remains to be seen.

Contact Paul Britt at [email protected].


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