It’s Hard to Run on Bond ETFs

We have talked a lot around here, over many years, about bond market liquidity and bond exchange-traded funds. People were worried about bond market liquidity, and they were worried that bond ETFs were somehow bad for it. For instance, last March, there was a lot of stress in the bond market, and some bond ETFs traded at discounts to their net asset value, and we talked a lot about that. I sort of thought we were out of things to say about bond market liquidity. But the March BIS Quarterly Review from the Bank for International Settlements has a cool special feature by Karamfil Todorov on “The anatomy of bond ETF arbitrage” that actually has something new and interesting to say about bond ETFs and bond market liquidity.

The way an S&P 500 exchange-traded fund works is roughly that the fund holds a big pile of all the 500ish S&P 500 stocks, and if anyone wants to buy or sell shares of the ETF they can trade with each other on the stock exchange. Sometimes people want to buy more shares than are for sale on the exchange, and so they will want to buy new shares from the ETF itself. But you can’t really buy new shares in the ETF, like you could in a mutual fund (you give the fund cash, it buys the underlying stocks, it gives you back shares). Instead there is a “creation” mechanism: There are firms called “authorized participants” (big broker-dealers and market makers) who go out and buy the underlying stocks and deliver them to the ETF in exchange for new shares of the ETF. An authorized participant will buy $10 million of S&P 500 stocks, hand them to the ETF, and get back $10 million of ETF shares.