A recent paper from the Bank for International Settlements (BIS) on bond ETF liquidity, a summary of which can be read here, has shown ETF issuers and authorised participants (APs) are engaged in a game of cat and mouse during the creation-redemption process.
The paper, entitled The anatomy of bond ETF arbitrage, said APs are responsible for warehousing huge numbers of riskier and illiquid bonds during periods of rapidly vanishing liquidity.
What it said was during periods of market stress such as last March, ETF issuers put only the illiquid and riskier bonds in redemption baskets for APs to take on.
This, the report said, allowed issuers to reassure non-running investors that their ETFs had higher than average quality bonds in the portfolios which in turn could prevent further contagion risks.
“Such a stabilisation mechanism was arguably in place during the March 2020 episode when some ETFs traded at a discount while redeeming baskets that were more illiquid than the holdings.”
However, the big question that arises from this is why would APs be prepared to allow riskier bonds onto their books, especially during periods of rapidly vanishing liquidity?
It is important to remember APs have no legal obligation to create or redeem ETF shares and therefore can walk away from a market if they choose to.
The answer is APs do not have a choice which bonds they receive from the ETF issuer in a redemption basket. As a result, they already price in the worst basket possible.
If APs do not want to take on the risk of those bond ETF redemptions then this can drive even higher discounts to net asset value (NAV), a factor that was in play during last March's volatility.
With bond ETF creation-redemption baskets not mirroring the underlying index holdings, this means APs can also move bonds they do not want on their books to the ETF issuer.
In fact, industry sources have told ETF Stream that APs do offload bonds they no longer want to warehouse into the ETF creation baskets, especially investment banks that run active businesses alongside their AP duties.
What happens is ETF issuers provide a set of guidelines to follow such as sector and country weights and APs will look to wrap the worst bonds they have within those guidelines into a basket.
Why would ETF issuers allow this? In author Karafmil Todorov’s words, they are incentivised to maintain a long-term relationship with APs which leads to differences between baskets and holdings.
As Todorov said: “APs of bond ETFs could also propose bonds that are not in the published basket but facilitate their role as dealers.”
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However, he did add the ultimate decision lies with the ETF issuer when choosing to accept an AP’s proposal or not.
The question that remains is how big of an impact do the bad bonds that sneak into the creation basket have on the performance of a bond ETF. Plenty of food for thought for investors.