As fixed income exchange traded funds have swelled in size, so have concerns that the funds could be vulnerable to crimped liquidity in their underlying assets.

Bond ETFs track a basket of fixed-income securities. Consequently, the ETFs are only as liquid as their underlying assets. In times of heightened market volatility, the bond ETFs may see a heavy redemptions, and without the necessary buyers in the underlying market, bid-ask spreads with rise and prices could fall even further. In the worst case scenario, bond ETF investors may even face a sudden fire-sale. [How ETFs Are Traded]

High-yield bond funds and bank loan ETFs, including the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) and the PowerShares Senior Loan Portfolio (NYSEArca: BKLN), have been previously criticized for tracking supposedly illiquid asset classes. However, HYG, BKLN and rival funds have been widely embraced by investors. HYG has $17.5 billion in assets while BKLN, the bank loan fund, has $5.7 billion in assets.

Some fixed-income observers are concerned that the low liquidity in the debt market could cause problems in bond ETFs if a large sell-off were to occur. For instance, selling pressure in the ETF may not be perfectly reflected by the illiquid underlying market, creating widening tracking errors between the ETF’s price and net asset value. [Of Bonds and Liquidity]

The iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEArca: LQD), one of the largest U.S. bond funds with $22.6 billion in assets, is an example of a sufficiently liquid ETF.

“Constituents of the iBoxx $ Liquid Investment Grade index and those of LQD have exhibited considerably more liquidity than the 16,500 investment grade $ bonds covered by the Markit bond universe in the first quarter of this year,” according to Markit.

Markit is LQD’s index provider. As investors found it more difficult to price fixed-income securities, many have turned to ETFs for their greater perceived liquidity. That includes LQD, which has added $2.9 billion in new assets this year, just below the $3 billion added by HYG.

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