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Is Liquidity Really an Issue for Fixed-Income ETFs?

Experts at the Morningstar ETF Conference define liquidity and discuss how bond-focused ETFs have managed during market duress.

Fixed-income ETFs have proliferated in terms of number and assets since the recession. As a result, some have argued that some ETFs could face liquidity challenges during times of market stress.

Morningstar's Sarah Bush explored the topic of bond ETF liquidity Thursday at the Morningstar ETF Conference with panelists Karen Schenone from BlackRock/iShares, Jerome Schneider from PIMCO, and Damon Walvoord from Susquehanna.

Liquidity Defined
Shenone kicked off the session by detailing the various definitions of liquidity. There's liquidity of the market in which the fund is investing, or the ability to transact in an asset without moving the price too much.

Then there’s the liquidity of the ETF as a vehicle. As Shenone noted, ETF investors can either sell their shares on the exchange or redeem their shares via the ETF sponsor. And sponsors can meet those redemptions in cash or in-kind, or by paying out a representative slice of the portfolio to the investor whose redeeming shares.

Those "in-kind" policies can vary from sponsor to sponsor, strategy to strategy, and day to day. With Blackrock/iShares, what an investor receives at redemption--cash or in-kind securities--depends on the day and how the portfolio is managed, says Shenone. Generally, in-kind redemptions are more common with index ETFs and cash-creation redemptions are more common with the firm's active ETFs, she adds. 

"We think of the cash-creation option as just that--an option," says Walvoord. "If we can accommodate, we do. Otherwise, you have the in-kind mechanic."

Liquidity and Stressed Markets
Shenone has observed three behaviors among ETFs during stressed liquidating environments, such as during the Taper Tantrum in 2012 or the high-yield-bond-market tumble in December 2015. During these times, ETFs tend to trade more on exchange, they may trade at a discount to NAV, and sponsors don't typically engage in selling within the portfolio because they usually meet redemptions that come to them by paying out in kind.

Walvoord added that bond ETFs can actually provide investors with more liquidity during market stress than they'd get if they invested in the underlying securities directly. He noted that while trading in the high-yield bond market dried up last December, trading in high-yield focused ETFs actually increased during that time.

Schneider said that last December, the bid/offer spreads in the high-yield market widened substantially. So while there was technically liquidity in the market--in other words, most bonds could be sold--that liquidity came at a cost, with the cost being that investors didn't receive the prices they might've liked for the bonds they were selling.

The bottom line: There's a cost to liquidity. Recognize your liquidity needs for the assets you're investing, and understand the underlying liquidity characteristics of the market an ETF is investing in. Schneider concludes that an ETF can give you liquidity that's about on par with underlying market, and maybe better. That's for all true for ETFs, not just bond-focused ETFs.