Money Managers Entreat SEC to Relax Rules on Bond ETFs

In an attempt to stay competitive against established bond ETF players, money managers seeking to expand in this growing ETF market are asking for the Securities and Exchange Commission to reconsider its review process and allow more flexibility in a notoriously illiquid segment of the market.

For fixed-income ETFs, early applicants can look at the inventory of debt securities held by authorized participants and choose the best ones to help track a benchmark, Bloomberg reports. However, ETFs launched after 2012 can only accept baskets from dealers that precisely reflect their benchmarks, which is basically impossible for bond funds that follow fixed-income indices comprised of hundreds if not thousands of different debt securities.

ETFs trade throughout the day like a stock on a stock exchange, and as prices fluctuate, a large trade order may cause the price to divert from its net asset value of the fund’s underlying index portfolio. Consequently, each ETF would swap securities for its portfolio by trading with stock and bond dealers or so-called authorized participants to ensure the ETF’s price reflects its underlying NAV. By exchanging for baskets of securities of the fund, the participant receives shares of the ETF it can hold or sell on the open market.

However, in a notoriously illiquid primary debt securities market, bond fund providers seeking a perfectly matched basket, which often may included very sparsely traded individual debt securities, will have a hard time finding the right authorized participant to make a swap with.

“It has always been a mystery to me why the SEC clamped down on the ability to do custom baskets,” said Peter Shea, an ETF specialist at law firm K&L Gates LLP. “People who got ETF exemptive relief before 2012 don’t have that straitjacket.”