“Once the ETF reaches a threshold outstanding notional (value), the secondary market is able to support its own trading activity without reliance on the creation/redemption cycle and the need to involve the underlying basket,” Perrotta said. “In essence, the ETF serves as an additional liquidity layer for the underlying market.”
Nevertheless, the cost of liquidity in the underlying securities provides the upper and lower bound for ETF trading spreads.
The “real downside risk scenario is not so much how the ETF prices, but what exactly is the imbalance between asset owners looking to transact and liquidity providers willing to make a market,” Perrotta said in the article.
When the upper or lower bands are reached, market-makers and authorized participants would create or redeem ETF shares and buy or sell underlying securities to arbitrage the spread between an ETF and its net asset value. In more volatile conditions, the underlying securities can trade at wider spreads, which could cause an ETF’s market price to experience greater premiums or discounts to the NAV.
For more information on the fixed-income market, visit our bond ETFs category.
Tom Lydon’s clients own shares of HYG and LQD.