Due to the Dodd-Frank reforms, banks have been hoarding bonds to meet regulatory requirements, which has diminished the number of debt securities floating around in the markets. Consequently, many are now concerned that a major bond market sell-off could exacerbate the effect of the liquidity mismatch in fixed-income ETFs.
ETFs create and redeem shares by swapping for a basket of underlying securities. In case of heavy redemptions, the ETF provider would need to sell shares of the underlying securities in the fund to meet the redemptions. However, if the underlying market is illiquid, the ETF provider may be forced to dump securities at any price, which could cause the share prices to rapidly decline. [How ETFs Are Traded]
With a credit line in place, fund providers can quickly payoff the redemptions without resorting to dumping the underlying securities.
However, ETF investors should note that these credit lines come at a cost. According to company filings, bank fees could range from 0.06% to 0.15%, which may be tacked on to an ETF’s annual expense ratio.
For more information on the ETF industry, visit our current affairs category.
Max Chen contributed to this article.