The Truth About Bond ETF Liquidity

ETF UNIVERSITY

Given how liquidity in the bond market has dried up, many investors understandably have come 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. If you’re reading this publication, you understand the basics, and that it occurs on two tiers—at the level of the securities an ETF holds (primary liquidity) and at the level of the ETF itself (secondary liquidity).

It’s More Than The Bonds
The bond market is more illiquid than the stock market. Many bonds trade infrequently. 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. An ETF’s liquidity is a function both of how it trades in the secondary market and how easily APs can create and redeem ETF shares. The liquidity of the bond market is only part of the puzzle.

In fact, because bond ETFs are so liquid, they can sometimes circumvent illiquidity in their underlying bonds because they’ll trade when their underlying bonds won’t. Research by BlackRock shows that bond ETFs trade, on average, four to five times more frequently than the underlying bond market.

Primary Liquidity Matters
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.

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 net asset value (NAV) before buying up the ETF shares to redeem if those underlying bonds are illiquid.

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

Liquidity When Rates Rise
If interest rates rise and liquidity dries up from the underlying bond market altogether, it’s unlikely investors will lose their shirts to mispricing 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 for a number of reasons, and the investment industry relies on bond pricing services, trading desk surveys, matrix models and so on for accurate pricing.

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 and 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’s shares trade regularly, and with high volume. Also in the case of a bond panic, ETF shareholders don’t get stuck bearing the costs of other shareholders exiting their positions, unlike what happens with mutual funds.

SELECTED TERMS

Counterparty Risk
It’s the risk an investor faces that whoever is on the other side of the deal might fail. For example, ETF issuers offer a pattern of returns for a given fee in an ETF wrapper. They can be a source of counterparty risk if they don’t deliver on what that ETF prospectus promises. Depending on the type of exchangetraded product, counterparty risk is higher or lower. Exchange-traded notes, which are debt instruments, pose counterparty risk associated with the institutions backing them and whether they can meet these debt obligations. ETFs that use a lot of derivatives contracts in their portfolios can also face counterparty risk stemming from the parties issuing these contracts.

Custom Basket
Like it sounds, a custom basket refers to a select grouping of securities, customized for a purpose. In ETFs, custom baskets come into play during the creation/redemption process for the purpose of improving tax efficiency. When ETF issuers rebalance portfolios, some ETF holdings may have incurred capital gains, which would have to be realized at rebalance. A custom basket is an in-kind mix of only certain securities the ETF issuer wants to trade (redeem) to avoid having to pass on capital gains distributions down the road. Until recently, only some ETFs were allowed to use custom baskets, but the Securities and Exchange Commission changed that when, in September 2019, it approved Rule 6c-11, known as the “ETF Rule.” Under the new rule, effective in 2020, all ETFs may use custom baskets, which is great news for ETF investors everywhere.

Market Maker
Also known as a liquidity provider, a market maker is someone who facilitates ETF trading, ensuring tight bid/ask spreads, depth and smooth trading throughout the day. Every ETF has a lead market maker, many of which are incentivized by exchanges to keep markets humming along.

Open-End Funds
These are portfolios of securities that have an elastic supply of shares that trade on an exchange at net asset value. ETFs and most mutual funds are open-end funds.

Securities Lending
This is the common practice of ETFs lending underlying securities to short-sellers. By lending out securities, the ETF picks up extra revenue that can ultimately lower overall costs and boost results for the ETF. If an ETF holds a hot in-demand security, lending it out can generate significant revenue for ETF shareholders. The biggest risk associated with this practice is counterparty risk.