By Carolina Carloni
In the second part of our look at fixed income ETFs, we examine how the creation and redemption mechanism supports the liquidity of ETFs.
In the first part of this blog, we covered some practical reasons why investors are increasingly using ETFs to access bond markets. In this instalment I will delve into the important topic of liquidity, explaining some of the processes that enable fixed income ETFs to trade efficiently at times when their underlying holdings may be experiencing a liquidity event.
In addition to the secondary market for ETFs, in which buyers and sellers create liquidity, ETFs can also potentially count on a second layer of liquidity. In situations where the secondary market fails to absorb the actual demand/supply, authorised participants (APs)1 can create (or redeem) new (or existing) shares in the primary market.
There are two main dealing types by which fixed income ETF shares can be created and redeemed: in-kind creations and redemptions, and cash creation and redemptions.
In-kind creations and redemptions
The in-kind mechanism allows an AP to work directly with the issuer’s ETF fixed income portfolio manager (PM) to create new shares of an ETF or redeem existing shares. The AP and the PM can both propose creation or redemption baskets of bonds to aim to best replicate the underlying index. The PM can select part of the basket or the basket in its entirety.
An important feature of the in-kind mechanism is its role in seeking to minimise the tracking error of the ETF compared with the index. From the list of ‘axes’ sent by the AP, the PM tends to take in bonds that the underlying portfolio is underweight versus the index in the case of a creation, and in the case of a redemption deliver bonds that the portfolio is overweight.
This provides an opportunity for the PM to rebalance the portfolio to the index without having to incur transaction costs inside the portfolio.
Additionally, the flexibility to propose a basket of bonds instead of the exact replication of the underlying itself makes this process particularly attractive in our view, particularly for ETFs with a high number of constituents that are difficult to source. The AP is not obligated to buy or sell each individual underlying bond, which could result in higher trading costs, but rather can optimise its inventory and save part of the cost. This advantage can then be passed to the final investor in the form of tighter spreads.
Cash creations and redemptions
A second option is to create or redeem a fixed income ETF unit in cash. In this case, the AP exchanges cash for a creation unit of ETF shares. The portfolio manager uses the cash to buy the underlying bonds in the open market and pass back the trading cost to the AP.
In the case of a redemption, the fund itself sells the underlying securities and passes the cash received to the AP.
The end result of these two dealing types by which fixed income ETF shares can be created and redeemed is an efficient and effective primary market, which benefits investors by creating liquidity and keeping spreads tight.
Even during periods of market disruption, fixed income ETFs have demonstrated resilient levels of liquidity and have been used as a price-discovery tool at times when the underlying bond markets are seized up.
In conclusion, we expect the potential benefits of accessibility, liquidity, transparency and cost-effectiveness to support the continued growth of the fixed income ETF market, just as ETFs have revolutionised how investors access equity markets.
This discussion of ETFs is for illustrative purposes only. The above information does not constitute a recommendation to buy or sell any security.
1. An AP is an entity with the exclusive right to create and/or redeem ETF shares directly with the ETF provider.
This article originally published on LGIM Blog on June 19, 2023.
For more news, information, and analysis, visit the Financial Literacy Channel.