CHAPTER
TWENTY-ONE
FIXED INCOME EXCHANGE TRADED FUNDS

MATTHEW TUCKER, CFA

Managing Director
BlackRock

STEPHEN LAIPPLY
Director
BlackRock

Fixed income exchange traded funds (ETFs) are a hybrid investment vehicle. Like a traditional mutual fund, a fixed income ETF is advised by an asset management firm that manages and rebalances the portfolio in accordance with stated investment guidelines. And like an exchange traded futures contract, a fixed income ETF provides investors with exposure that can be traded throughout the day on an exchange.

Fixed income ETFs possess three key attributes:

Exchange listing provides transparent, intraday liquidity. This is in stark contrast to the underlying over-the-counter (OTC) bond market, which can be less transparent and less liquid.

A mechanism for creating and redeeming new fund shares. The number of outstanding shares adjusts to market supply and demand. This differs from closed-end exchange traded funds, which have a fixed number of shares. As a result, fixed income ETFs avoid some of the premium and discount volatility experienced by traditional closed-end funds.

Targeted market exposure. Exchange traded fund managers rebalance the funds and manage cash flows with the objective of providing risk and return characteristics that track (in the case of an index ETF) or seek to outperform (in the case of an active ETF) a published market index.

In this chapter, we discuss the characteristics of fixed income ETFs and how they compare with other fixed income instruments. We will then explore various investment applications of fixed income ETFs for individual investors, advisors, and institutions. Finally, we examine the structure and management of these funds as well as their trading behavior.

The authors would like to thank Chris Barr, Marcia Roitberg, and Karen Schenone for their review and comments.

INVESTMENT CHARACTERISTICS

Exchange traded funds provide several key benefits:

Low investment management fees. ETFs generally have lower fees than open- and closed-end mutual funds. The average management fee is 27 basis points (bps) for a fixed income ETF versus 66 bps for the average fixed income mutual fund.1

Transparency. Holdings of most fixed income ETFs are published on a daily basis. This gives investors regular access to the funds’ assets and risk exposures.

Intraday liquidity. The ability to trade fixed income ETFs throughout the trading day provides investors with greater visibility into portfolio valuation, even during periods of volatility and illiquidity.

Tax efficiency. The ETF creation/redemption mechanism makes ETFs more tax efficient than traditional mutual funds. When ETF shares are redeemed, the fund delivers securities in-kind (meaning that the underlying securities, rather than cash, are distributed). This in-kind distribution is not considered a taxable event for capital gains purposes. Mutual funds and other vehicles that distribute cash for redemptions must sell securities to raise the cash; in doing so, they potentially realize capital gains (or losses), which are paid to investors in the form of capital gains distributions.

Investment breadth. Exchange traded funds provide exposure to a wide array of sectors for which futures and other exchange traded vehicles do not exist.

Risk control. Because they are exchange traded, and because each fund’s underlying securities are held in a separate custodial account, fixed income ETFs have minimal counterparty risk.2

Exhibit 21–1 outlines the characteristics of ETFs along with other commonly used fixed income exposure vehicles: individual fixed income securities, futures, and swaps.

EXHIBIT 21–1
Key Characteristics of Bonds, ETFs, Futures, and Swaps

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Fixed income ETFs are used by both retail and institutional investors to obtain fixed income exposure across a broad asset class or a specific sector. Retail investors utilize these funds primarily as core portfolio exposure vehicles. Institutional investors utilize the funds primarily as liquid fixed income access vehicles.

Retail Investors and Financial Intermediaries

Retail investors and financial intermediaries use fixed income ETFs alongside traditional vehicles such as open- and closed-end mutual funds and separately managed accounts, primarily through three strategies:

Core exposure: As with traditional types of funds, fixed income ETFs can be used for core fixed income exposure. A core holding typically provides an investor with broad market exposure. Around this core, exposure to other sectors can be added to satisfy particular risk/return targets. The wide selection of fixed income ETFs enables investors to construct core fixed income exposure either with a single broad market ETF (such as an ETF that is benchmarked to the Barclays Capital U.S. Aggregate Bond Index) or with multiple ETFs that track various government and credit sectors which, when combined, provide broad market exposure.

Custom exposure: Fixed income ETFs can provide targeted exposure to a specific market, allowing investors to tailor portfolios for specific investment objectives or constraints. This application is widely used by individuals and is especially popular among investment advisors, because it allows them to customize fixed income exposure for a large number of individual clients in a scalable way. As an example, an investor who holds a core position in an aggregate bond ETF may wish to periodically overweight exposure to investment-grade credit. The investor may accomplish this by augmenting their core exposure with a tactical allocation to an investment-grade credit ETF. Similarly, an investor may wish to shorten or lengthen the U.S. Treasury duration exposure of their core holding and may do so by blending in shorter or longer duration U.S. Treasury ETFs.

Market access: The ability to target specific fixed income markets with a low-cost, liquid investment vehicle allows investors to gain exposure to market segments such as high yield or emerging markets that can be challenging to access through the underlying bond market. As an example, an individual investor may find a broad emerging market bond allocation difficult (if not impossible) to obtain using individual bond issues. However, there are a number of ETFs on the market today that allow investors to gain access to this challenging fixed income sector instantaneously through an exchange.

Institutional Investors

Institutional investors rely on ETFs’ liquidity, transparency, flexibility, and relatively low-cost structure to implement the following commonly used investment strategies:

Cash equitization: Cash equitization involves short-term investments of excess cash to maintain market exposure. Futures are commonly used for cash equitization due to their liquidity and ease of trading. Cash is invested in a money market account, and the futures position serves as an overlay to obtain the desired market exposure. The challenge with futures is that they offer exposure only to money markets or U.S. Treasuries. Over-the-counter swaps (e.g., index total return swaps) may provide precise, customized exposure to a variety of fixed income sectors, but may exhibit less liquidity and potentially result in higher transaction costs relative to exchange traded instruments, are subject to counterparty risk, and can be opaque and operationally intensive. Conversely, fixed income ETFs provide access to a wide range of fixed income sectors through an exchange traded vehicle.

As an example, a manager benchmarked to a broad index—such as the Barclays Capital U.S. Aggregate Index—would ideally employ a cash equitization instrument to minimize cash drag and maintain exposure to the index. While U.S. Treasury futures are liquid, they have a very high tracking error versus the Aggregate index, due to the differences in sector exposure and the presence of the delivery option in the futures contract. A number of fixed income ETFs exist that would allow the manager to invest excess cash efficiently and cost effectively without significantly increasing portfolio tracking error.

Transition management: When investors restructure their portfolios (e.g., due to changes in their manager profile or strategic asset allocation), they risk significant performance gaps and excessive costs. There is a trade-off to be managed with respect to moving assets quickly and potentially incurring higher trading costs, and moving assets more slowly, which can result in performance differences relative to the target exposure. As an example, a pension plan that is moving a significant amount of money into the corporate bond market may find that it takes days or weeks to build the desired exposure through individual bonds. While the bond portfolio is being constructed, the plan is underexposed to any market movements that may occur in the corporate bond market. Futures and OTC swaps can be utilized to quickly obtain market exposure, but the tradeoffs discussed previously would still apply. The pension plan could instead purchase a fixed income ETF to rapidly establish and maintain corporate bond market exposure while it assembles the target bond portfolio.

Tactical allocations: To take advantage of a market opportunity, a tactical investor must be able to move in and out of the market quickly. Individual bonds can provide targeted exposure but are generally difficult to trade in a large, diversified basket format. Futures and OTC swaps can be utilized, but there are tradeoffs, as discussed previously.

Fixed income ETFs combine the liquidity of futures and the diversified exposure of index total return swaps. For example, an investor favoring the wide level of credit spreads in 2009 could have purchased a corporate bond ETF far more quickly and efficiently than buying an equivalent portfolio of individual securities. Investment advisors often use fixed income ETFs for tactical plays across a large number of accounts to implement market views more rapidly and cost effectively than they could otherwise through the underlying bond market.

Portfolio rebalancing: Investors typically establish a portfolio-level strategic asset allocation based on their investment objectives and risk tolerance. Once this policy is set, the challenge is to maintain these target allocations, especially in fast-moving and illiquid markets. It can be difficult to access liquidity through managed vehicles and individual securities without incurring significant transaction costs.

Index ETFs are often used by pension plans to address these challenges as part of a core liquidity component within the broader portfolio. The ETF investment represents a portion of the exposure to each asset class. In this way, it complements, rather than replaces, the core plan holdings. The ETF portfolio provides a liquidity sleeve around the overall portfolio that can be accessed as needed to effect rebalancing. This approach allows the pension fund to maintain a strategic asset allocation without the need to continuously access the less-liquid portions of their portfolio. It is especially valuable in fixed income markets, in which bid/offer spreads in individual securities can be significant and liquidity can be discontinuous.

Advanced Applications

In addition to the more conventional applications discussed above, tactical investors may also employ fixed income ETFs in more advanced strategies involving options, short selling, and vehicles that contain packaged leverage.

Options: As the market for fixed income ETFs has grown and developed, exchange traded options have been listed on a number of the funds. Trading strategies using these options can be structured in a manner similar to those employed in futures options or OTC fixed income options. Options on fixed income ETFs allow investors to access leveraged market exposure and pursue a variety of strategies such as call or put spreads, and directional volatility bets through straddles. Because they are exchange traded, options on fixed income ETFs may be attractive relative to OTC fixed income options in terms of cost, transparency, and operational ease.

Short selling: Investors who wish to short a specific fixed income sector may find that such a strategy is easier to implement through a fixed income ETF rather than through the underlying bond markets. Like stocks, shares in fixed income ETFs may be borrowed and sold short. The cost varies with supply/demand conditions in the market for the ETF and helps shape an investor’s decision on whether to use the ETF or an alternative strategy to short the market. Additionally, dislocations in the cost to borrow a fixed income ETF can create investment opportunities.

As an example, a relative value hedge fund may find that the borrow cost in a particular high-yield ETF has increased from 1% to 5%, due to a significant level of short interest. The hedge fund may choose to take advantage of this situation by purchasing the high-yield ETF and lending it out at a rate of 5%. (Note that borrowing and lending spreads vary.) This would allow the hedge fund to achieve the return of the high-yield ETF plus 5%. Furthermore, the hedge fund may find that the high-yield beta exposure can be hedged by shorting a basket of correlated securities. If the cost of shorting the correlated basket of securities is less than 5%, then the hedge fund earns a spread for as long as the dislocation persists. In this example, the hedge fund must also price in the potential basis risk between the ETF and the correlated basket.

Leveraged and inverse ETFs: There are a growing number of ETFs that provide investors with the ability to gain leveraged long and short exposure to fixed income markets. These funds have attracted interest from investors who seek to implement short-term tactical strategies on the direction of the targeted fixed income sector and who are comfortable with the mechanics and implications of leverage. These funds typically achieve their target exposure and leverage synthetically through OTC total return swaps or exchange traded futures.

Investors considering these investments should be aware that the majority of leveraged and inverse funds reset leverage to a target level on a daily basis. Since the benchmark itself is not levered, the use of fund leverage coupled with the impact of market path dependency and return compounding can potentially distort fund returns relative to levered benchmark returns over longer periods of time.

FIXED INCOME ETF MANAGEMENT

Because fixed income ETFs are managed funds, an investment advisor is charged with overseeing the portfolio and delivering on its investment objective in accordance with a published prospectus and Statement of Additional Information (SAI). The manager has full investment control of the positions and transactions in the portfolio. There are two primary types of funds in the marketplace—index funds and active funds.

Index ETFs

The majority of fixed income ETFs are index funds, which seek to match the performance of a published benchmark. Many fixed income securities have discontinuous liquidity, making it virtually impossible to fully replicate a broad market benchmark. For this reason, most fixed income index ETFs employ a set of techniques to sample from the broad market. These approaches, the most common of which are optimization and stratified sampling, involve creating a portfolio that contains a subset of the securities from an index that match the major risk characteristics of that index. In constructing and maintaining a portfolio, the manager must balance available security liquidity and transaction costs with the objective of creating a diversified portfolio to reduce idiosyncratic risk and better track benchmark performance.

Active ETFs

In 2008, the first active fixed income ETF was launched, nearly 20 years after the first index ETF. Like their index counterparts, active ETFs also have a stated benchmark. But unlike index funds, their objective is to outperform the benchmark. Active ETFs are not typically used by investors as liquid exposure vehicles in the same way that index ETFs have been used, as they do not have the same targeted market exposure. What active ETFs do offer is a managed alpha vehicle that can be accessed and traded throughout the day.

Managers of active fixed income ETFs employ an array of investment strategies to achieve outperformance including security selection, asset allocation, and duration management. This is similar to the management of a traditional open- or closed-end mutual fund.

As with index ETFs, active fixed income ETF providers publish their holdings on a daily basis, which creates challenges for a portfolio manager when holding concentrated positions or investing in illiquid markets. For this reason, the active fixed income ETFs that have entered the market to date are those that invest in more liquid asset classes or that hold securities until their maturity. This minimizes the chances of the manager being taken advantage of by opportunistic investors because of their posted holdings.

FIXED INCOME ETF CHARACTERISTICS AND MECHANICS

Fixed income ETFs typically provide daily transparency of holdings and pay income through monthly distributions. The liquidity provided by fixed income ETFs is supported by two complementary markets—the primary market, in which fund shares are created and redeemed, and the secondary market, in which existing shares are traded throughout the day on a stock exchange.

Holdings Transparency

A differentiating factor of fixed income ETFs is that their holdings are disclosed more frequently than mutual funds. The majority of fixed income ETF providers publish holdings on a daily basis, providing investors with continual transparency into the fund’s risk profile. The exceptions are ETFs that represent share classes of mutual funds as well as those ETFs that have received specific regulatory exemptions.

Fund Distributions

As 1940 Act mutual funds, fixed income ETFs are required to distribute earned income to investors. This income reflects accrued interest earned by the fund and includes the amortization and accretion of securities purchased at a price other than par as well as securities lending income and fund management expenses. Typically, fixed income ETFs distribute income monthly. Earned income may be generally defined as:

Earned Income = Accrued interest + bond accretion – bond amortization
+ securities lending income – fund expenses

It is important to note that income is earned at the fund level but distributed at the share level. As a result, changes in the number of shares outstanding in a given month can result in a change in the size of the distribution on a per share basis paid to investors. Value is neither created nor destroyed, however. Any perceived surplus/deficit in per share distributions is offset directly in the net asset value (NAV). For established funds with moderate flows, this tends to result in small shifts in distributed income on a monthly basis; for smaller funds and those that experience extreme flows, the impact can be greater. Note that this income distribution mechanism is not unique to ETFs. Investors should be aware that it applies to other mutual fund structures as well.

Fixed income ETF distributions are an important attribute for investors who invest in bonds for income purposes. Distributions create a future stream of cash flows that an ETF holder will receive, in much the same way that an individual bond provides a future stream of coupon payments.

The Primary Market: Creation and Redemption of Fund Shares

Broker-dealers who create or redeem ETF shares are known as authorized participants (APs). Authorized participants generally work with both investors and ETF providers to maintain liquidity in the market.

Investors purchase and sell shares of ETFs on an exchange, trading them in exactly the same way as a listed stock. Each share represents partial ownership of the portfolio of securities held by the fund, much like shares in a traditional open-end mutual fund represent partial interest in the underlying fund holdings. What differs is the ETF’s creation/redemption mechanism.

On a daily basis, the ETF provider publishes the holdings of the ETF along with the lists of securities that can be delivered for the creation or redemption of shares. When there is strong buying demand for an ETF on the exchange, market makers can sell out of their available inventory. In order to replenish this inventory, APs will purchase a portfolio of individual securities and then deliver these securities in-kind to the ETF provider in return for new ETF shares. This same mechanism works when there is strong selling pressure for a fund, which results in APs holding additional ETF shares. These shares can be delivered in-kind to the ETF provider in return for a basket of individual bonds that then can be sold. This market-driven ETF inventory management mechanism prevents a significant, persistent divergence in the price between the ETF and the underlying fund securities.

During periods of strong demand for an ETF, the price of the shares is bid up in the market. If the ETF price is sufficiently higher than the value of the underlying securities held within the ETF, an arbitrage opportunity may exist. Authorized participants could purchase the underlying fixed income securities, deliver them to the ETF provider in exchange for new ETF shares (i.e., create new shares), and then sell the newly created ETF shares in the market for a profit.

This same dynamic occurs in markets with strong selling pressure. If the ETF trades significantly or persistently below the value of the securities in the fund, APs could purchase the ETF shares in the open market (at a discount), deliver them to the ETF provider in exchange for the underlying bond holdings (i.e., redeem these shares), and then sell these bond holdings at a net profit. Arbitrage pressure keeps the ETF price in line with the value of the underlying securities.

Note that one need not be an AP in order to close an arbitrage opportunity in an ETF. As an example, if an ETF is trading at a discount relative to the value of its underlying securities, then a market participant (such as a hedge fund) may act to close the valuation gap by buying the ETF and selling short against it a basket of correlated securities or derivatives. The correlated basket could consist of individual bonds, interest rate swaps, or credit default swaps. The hedge fund would wait for the values of the ETF and the correlated basket to converge. At that time, all positions would be unwound for a net profit.

All creations and redemptions must be done at a value equal to the fund’s NAV. This ensures that the value of the securities passing into or out of the fixed income ETF matches the value of the shares issued by or taken back by the fund. In this way, existing shareholders of fixed income ETFs are protected from any potential transfers of wealth during the share creation/redemption process.

Additionally, investors entering or leaving the fund transact at the market price of the fund, as opposed to the NAV. Market price execution is an important point of differentiation for a fixed income ETF relative to traditional open-end fund structures. In an ETF that utilizes the in-kind creation/redemption process, each investor incurs the transaction costs created by their specific transaction through the market price of the ETF (i.e., the market price should reflect the cost of share creation) and existing investors are unaffected. Conversely, in a mutual fund structure, investors enter and leave the fund at the fund’s net asset value, as opposed to market price, and transaction costs are shared by all investors in the fund. Note that it is customary to value fixed income securities on the bid side of the underlying bond market for NAV calculation purposes, while investors typically purchase fixed income securities on the offered side of the market. As a result, a new investor may enter a mutual fund at the NAV, but the securities purchased as a result of this investor’s entry may ultimately cost more than the bid side prices that were implied by the NAV. This differential is paid for by existing investors in the fund.

Such a dynamic is generally beneficial for the transacting investor but not the existing investors. An investor’s choice of whether to use an ETF or a mutual fund depends, in part, on their desire to incur isolated or mutually shared costs.

The Secondary Market: The Exchange Liquidity Layer

One of the characteristics that differentiate fixed income ETFs from other managed vehicles is that the shares are listed and traded on a stock exchange. Unlike the OTC bond market, the exchange format provides for a high level of visibility into trading volumes, two-sided market levels (both bid and offer), and transaction costs. It also provides investors with the ability to control market execution by using equity trading strategies such as limit orders and stop loss orders, and employ shorting strategies by borrowing ETF shares and selling them into the market.

The level of intraday liquidity and market visibility offered by ETFs is in sharp contrast to the underlying OTC bond market where trades are negotiated directly between parties by phone, e-mail, or other medium. The OTC market creates a number of challenges for an investor. First, it is difficult to determine best execution. An investor can solicit market bids or offers from a selection of dealers, but that investor has no way of knowing whether they executed at the best available price in the market. Second, OTC markets generally provide either the bid or offer price for a transaction, whereas two-sided markets allow the investor to explicitly observe their transaction costs through the spread between the bid side and offer side prices.

One of the central benefits of ETFs is that they develop their own independent exchange liquidity layer through the secondary market as trading volume and shares outstanding grow. Secondary market activity accounts for the majority of ETF trading volume, as most transactions occur without the need to create/redeem shares and access the underlying market. This secondary market liquidity is a key benefit of ETFs in general and fixed income ETFs in particular. The liquidity layer essentially decouples the ETF liquidity from that of the underlying OTC bond market and allows investors to trade in the ETF without having to create or redeem shares. The ability to trade a fixed income ETF within the exchange liquidity layer can result in the ETF trading at a much tighter bid/offer spread than the underlying bond market. When trading demand outstrips available exchange liquidity, the market price action of the fixed income ETF may motivate dealers to access the underlying bond market in order to square orders with inventory.

Accordingly, the level of liquidity available for a fixed income ETF is not driven by the level of observable exchange liquidity alone. A large purchase or sale in a fixed income ETF may potentially absorb the existing level of exchange liquidity, which would then necessitate the creation or redemption of shares by an AP in order to balance the market. The AP would do this by accessing the underlying bond market (i.e., purchasing bonds to facilitate share creation or selling bonds to facilitate share redemption). Accordingly, the total available liquidity of a fixed income ETF is a function of not only the observable exchange liquidity but also liquidity of the underlying bond market (which is substantial in most fixed income sectors).

A fixed income ETF’s total available liquidity may be thought of as the sum of:

1. Observable exchange liquidity (i.e., the average daily volume),

2. Contingent exchange liquidity that may be unlocked through the use of limit orders, etc. (which is provided by existing fund shareholders who are willing to transact at a price that is more favorable to them than what is currently available in the market), and

3. Underlying bond market liquidity that may be accessed through the creation/redemption process.

Through careful execution designed to maximize observable and contingent exchange liquidity, market participants are often able to transact in fixed income ETFs at several times the average daily volume with minimal market impact. Exhibit 21–2 illustrates the layers of liquidity of fixed income ETFs.

EXHIBIT 21–2
Fixed Income ETF Liquidity Layers

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Exhibit 21–3 presents observed bid/offer spreads for trades on some of the largest fixed income ETFs relative to spreads in the respective underlying market. Note that, because of the robust exchange liquidity in these ETFs, their bid/offer spreads are a fraction of the underlying bond market bid/offer spreads. This is particularly pronounced in the more esoteric sectors such as high yield and emerging markets.

EXHIBIT 21–3
Sample ETF and Market Bid/Offer Spreads

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TRADING BEHAVIOR: A CLOSER LOOK AT PREMIUMS AND DISCOUNTS

The price at which an ETF trades is primarily a function of the value of the underlying securities in the portfolio and is also influenced by market flows, liquidity, and market volatility.3

When an ETF trades at a price above the NAV, it is said to be trading at a premium; when the ETF is trading below the NAV, it is said to be trading at a discount. Because the convention in fixed income markets is to value securities using bid-side prices, the NAV of a fixed income ETF is calculated using the bid side of the underlying bond market. Under most market conditions, a fixed income ETF will trade at a premium to this bid-side NAV.

The level of premium or discount for a fixed income ETF is a function of the bid/offer spread of the underlying bond market, the balance of ETF flows, and the level of market volatility and execution risk that a market participant takes on in executing the creation/redemption or arbitrage activity.4

The market price-to-NAV relationship of a fixed income ETF can be summarized conceptually as:

Fixed income ETF premium/discount = (creation cost × flow factor) + execution risk adjustment

Where

Creation cost equals the bid/offer spread in the underlying market, Flow factor is a scalar between 0 and 1, representing the balance of ETF flows in the market (0 = all sell orders; 1 = all buy orders), and Execution risk adjustment equals the cost of basket execution and intraday hedging to facilitate creation/redemption.

Creation Cost

Creation cost is the cost of originating new fixed income ETF shares and is generally the largest driver of fixed income ETF premiums. The creation cost reflects the cost of acquiring bonds in the underlying market, and its magnitude varies according to the liquidity and level of transaction costs in the underlying bond market. Because the creation cost impact on the ETF premium is incurred only by new investors (i.e., those paying the market price to acquire shares on the exchange), existing investors in the fund are not affected.

As bond market liquidity changes through time, so does the level of transaction costs. This leads to changes in the creation cost and, as a result, the level of the ETF premium. This dynamic was clearly observed during 2009 when there was a significant shift in market liquidity. Exhibit 21–4 depicts the premium on a Treasury Inflation Protected Securities ETF (the iShares Barclays Capital TIPS Bond Fund) versus the bid/offer spread in the underlying TIPS market during 2009. As TIPS market liquidity improved, and the bid/offer spread on TIPS declined, the creation cost of the ETF (as reflected in the premium) also declined.

EXHIBIT 21–4
TIPS ETF Premium versus 10-Year TIPS Bid/Offer Spread

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Some fixed income ETFs facilitate the creation of new shares either entirely or partially by receiving cash rather than an in-kind basket of individual securities. The fund itself (rather than the AP) acquires bonds in the open market, thereby directly incurring the cost of execution, which is absorbed by existing fund investors rather than the marginal investor. These funds generally trade at a lower premium than funds that utilize an in-kind creation/redemption methodology, as the cost of new share creation is borne by existing investors and is not reflected in the ETF price.

The Flow Factor

The balance of ETF flows in the market, known as the flow factor, drives how much of the total creation cost is priced into the ETF and where the ETF bid/offer spread resides within the underlying portfolio bid/offer spread. The flow factor is a scalar between 0 and 1 that represents the percentage of purchases versus sales of the fund relative to the available exchange liquidity. A flow factor near a value of 1 indicates a high level of net purchases relative to the available exchange liquidity, and may result in share creations. In this case, the market price of the ETF likely reflects the offer side of the underlying bond market. Conversely, a flow factor near a value of 0 indicates a high level of net sales relative to the available exchange liquidity and may result in share redemptions. In this case, the market price of the ETF likely reflects the bid side of the underlying market.

Exhibit 21–5 represents the dynamics of the ETF liquidity layer in a balanced market and the impact of the flow factor on creation cost. The dark gray area represents the underlying bond portfolio bid/offer, or the full creation cost for an in-kind creation fund. The shaded area represents the ETF bid/offer. In markets where secondary trading flows are balanced, the flow factor will be roughly at the midpoint (approximately 0.5), and the ETF bid/offer will rest near the midpoint of the underlying portfolio bid/offer, all else being equal.

EXHIBIT 21–5
ETF Trading Behavior in a Balanced Market

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Execution Risk Adjustment

An ETF’s execution risk adjustment represents the execution and liquidity risk that broker-dealers bear when executing trades and aggregating bond portfolios to facilitate share creation and redemption. Because the execution risk adjustment is a measure of execution risk, its magnitude is driven by the level of volatility and overall liquidity conditions in the market, while its direction is driven by whether the broker-dealer is creating or redeeming ETF shares (generally positive for creation, generally negative for redemption).

Recall that the NAV represents a weighted average of the underlying bond bid-side prices and does not reflect the economics of a simultaneous basket execution. In less liquid or less transparent markets, the theoretical bid/offer for a given bond can be highly tenuous and may only apply to a very narrow size of execution. Accordingly, broker-dealers may encounter difficulty in sourcing or selling bonds to satisfy a specified creation or redemption basket for a certain size of transaction. The level of the execution risk adjustment reflects the uncertainty around price discovery and liquidity. In highly stressed markets, the execution risk adjustment may be significant, allowing for larger-than-normal premiums or discounts.

Exhibit 21–6 shows a situation in which market pressures have pushed the price of the ETF to a discount. Note that the ETF bid/offer is less than the theoretical bid side of the portfolio, indicating that the broker-dealer has determined that the true liquidation value received when redeeming shares lies below the theoretical bid side of the portfolio. The distance between them (the white area) is the execution risk adjustment.

EXHIBIT 21–6
ETF Market Price at a Discount to NAV

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KEY POINTS

• Fixed income ETFs combine many of the attributes of individual bonds, mutual funds, swaps, and futures to provide transparent, liquid, efficient, and cost-effective exposure for investors.

• Retail and intermediary investors use fixed income ETFs primarily for core or custom exposure and market access; institutional investors use these instruments for cash equitization, transition management, tactical allocations, and portfolio rebalancing.

• In the primary market for fixed income ETFs, authorized participants help maintain liquidity by increasing shares of the ETF (when demand increases) or decreasing shares of the ETF (when demand decreases). Arbitrage pressure keeps the ETF price in line with the value of the underlying fixed income securities.

• In the secondary market, investors trade ETF shares on a stock exchange. This added liquidity layer may provide significantly tighter bid/offer spreads relative to those observed in the underlying bond market.

• Fixed income ETF pricing behavior is driven primarily by movements in the underlying bond market, but is also affected by ETF fund flows and the level of market volatility.

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