Many fixed-income observers are concerned that a sudden rate hike would cause liquidity to dry up as sellers outweigh buyers. However, bond exchange traded funds may have a buffer to diminish the ill effects as a result of its structure.
Specifically, market watchers believe that after banks and institutions hoarded fixed-income securities, more investors have turned to bond ETFs in response to the lack of liquidity across the underlying markets, which could set the stage for liquidity problems if ETFs experience large redemptions. [Liquidity Concerns in Corporate Bond ETFs]
Market-making activity and principal trading desks at broker-dealers have shrunk, and a new group of market-makers and arbitrageurs have stepped in, reports Ari I. Weinberg for Pensions & Investments. This growing group of authorized participants that create and redeem ETF shares might have a smaller affect prices. [How ETFs Are Traded]
For starters, the bond ETF market is still relatively small, compared to the larger fixed-income market. According to XTF, corporate-specific bond ETFs held about $95 billion in assets, whereas the overall corporate market has accumulated $7.8 trillion at the end of 2014.
Anthony Perrotta Jr., head of fixed-income research at TABB Group, argues that high ratio of dollars traded in ETFs versus dollar flow into or out of the fund indicates a fund’s ability to meet higher trading activity without causing creations or redemptions that would directly impact underlying prices
For instance, the $16.2 billion iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) and $21.8 billion iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEArca: LQD) have an average turnover ratio of 7-to-1 at the end of 2014.
“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.