Understanding bond ETF liquidity

Fixed-income exchange-traded funds are growing fast, but some common myths and misunderstandings about bond ETF liquidity continue to persist. We take a closer look at why it’s so important to consider more than just an ETF’s trading volume or assets when evaluating the liquidity of individual ETFs.

understanding-bond-etf-liquidity

Nearly 20 years of bond ETF history

The first U.S. fixed-income ETFs didn’t appear until 2002, or nearly a decade after the first equity ETF launched in 1993. The majority of ETF assets today are in stock-focused funds, but bond ETFs are coming on strong as investors look for strategies to boost yield in a low interest-rate environment.

Although fixed-income ETFs are newer, they have already successfully weathered several big storms, including the global financial crisis, the 2013 taper tantrum, and the COVID-19 panic. But despite that track record, some myths about bond ETF liquidity refuse to die. Part of it may be that the stock and bond markets trade and settle differently. As part of our continuing efforts to help ETF investors know what they own, we wanted to shed some light on how bond ETF liquidity works in practice.

Bond ETF liquidity: look beyond trading volume

Investors are right to focus on liquidity, whether it’s an ETF, an individual security, or virtually any asset. Liquidity—the ability to buy or sell a security quickly and easily—is an important factor to understand and to monitor with any investment.

When judging the liquidity of individual stocks or securities, most investors start by looking at trading volume. Large blue chip companies, for example, are some of the most liquid securities in the world, with millions of shares transacting daily; small companies, with far less trading volume, are less so.

An ETF’s liquidity is primarily driven by the liquidity of the assets it holds.

When it comes to ETFs, investors can easily check on an individual ETF’s average daily trading volume, typically measured in shares traded. In the ETF industry, this is known as the secondary market for ETFs, and it’s how most individual investors buy and sell ETFs.

That said, it can’t be stressed enough: Investors need to look at more than an ETF’s trading volume to accurately assess its true liquidity. That’s because an ETF’s liquidity is primarily driven by the liquidity of the assets it holds. This is true whether the ETF holds stocks or bonds.

Bond ETF creation and redemption

With ETFs, it’s important to remember that brokers known as authorized participants (APs) can create or redeem ETF shares, based on changes in demand for the ETF.¹ This is known as the primary market for ETFs.

When the securities the ETF invests in are liquid, it’s easier for APs to create and redeem ETF shares. In other words, the liquidity of an ETF’s underlying holdings drives the ability of APs to create and redeem shares, and provide liquidity to potential ETF shareholders, regardless of the ETF’s daily trading volume.

For example, bond ETFs with relatively little trading volume can still trade at tight spreads if they invest in liquid markets such as U.S. Treasury bonds, investment-grade corporate debt, and mortgage-backed securities.

Taking all the data into account may help investors get a better handle on a bond ETF’s liquidity.

How to do your homework on bond ETF liquidity

Investors can check an ETF’s trading volume, as well as bid/ask spreads, and premiums and discounts to net asset value (NAV).² Taking all the data into account may help investors get a better handle on a bond ETF’s liquidity when it comes to actually buying and selling ETFs. It’s also a good idea to see if the ETF issuer has a capital markets team that can help facilitate large trades if necessary.

I’ve recently written about ETF do’s and don’ts in volatile markets, such as the pandemic-induced sell-off in 2020. These include using limit orders for ETF trades and avoiding buying or selling ETFs near the market open and close. I’ve also tried to help investors understand why premiums and discounts happen in bond ETFs when they are being used for price discovery, as happened in the early COVID-19 volatility.

As bond ETFs continue to grow nearly two decades after their introduction, it’s more important than ever for investors to understand bond ETF liquidity.

 

1 “Bond ETFs show maturity during Covid market mayhem,” FTSE Russell, October 2020. There can be no assurance that active trading markets for the shares will develop or be maintained by market makers or authorized participants, and there are no obligations of market makers to make a market in the fund’s shares or to submit purchase or redemption orders for creation units. Although market makers will generally take advantage of differences between the NAV and the trading price of fund shares through arbitrage opportunities, there is no guarantee that they will do so. Decisions by market makers or authorized participants to reduce their role with respect to market making or creation/redemption activities in times of market stress could inhibit the effectiveness of the arbitrage process in maintaining the relationship between the underlying value of the fund’s portfolio securities and the fund’s market price. This reduced effectiveness could result in shares trading at a discount to NAV and also in greater-than-normal intraday bid/ask spreads for shares.