Examine the different order types for trading fixed income ETFs and learn the key considerations for choosing your trading venue based on your execution priorities.
There are two primary options for trading fixed income ETFs: on exchange and off exchange, which is also known as over the counter (OTC). As a result, there are a handful of order types that exist for the trading of fixed income ETFs.
Risk Trade (OTC) For larger block trades, investors can engage liquidity providers for immediate execution. Market makers will offer a single price execution for the order, manage the risk, and create or redeem ETF shares as needed. Execution can be easily measured against the ETF-indicative NAV calculation, national best bid and offer (NBBO), and/or arrival price. The increase of Request-For-Quote (RFQ) platforms have created streamlined tools for buy-side clients to access large pools of liquidity providers anonymously. Many of these platforms offer additional services, including built-in trade analysis and historical best execution reporting.
NAV Trade (OTC) Orders can be benchmarked to official NAV pricing for investors seeking to benchmark their execution to bid/ask in fixed income terms, or those whose performance is benchmarked to a broader index. It is also important to be aware that the ETF execution costs can be measured in traditional fixed income metrics, namely in terms of yield and spread.
Working Order (exchange) Stop and limit orders are known together as working, or pending, orders. Essentially, they’re instructions for a broker to make a trade when an asset hits a certain price. A stop/limit order allows traders to better control the prices at which they trade. While the price is guaranteed, the filling of the order is not, and these orders will not be executed unless the security price meets the order qualifications.
Market On Open (MOO)/Market On Close (MOC) (exchange) These types of orders offer easily measurable execution targets based on the opening or closing US ETF market price; however, caution is needed when using these order types when trading ETFs. The market for MOO/MOC orders for an ETF may differ dramatically from that of the underlying securities and NAV calculations.
To trade on an exchange, an investor simply needs access to a front-end trading platform and a brokerage or custodial account. If the firm is self-clearing, the investor also needs a Depository Trust Company (DTC) number.
To access primary markets or trade off exchange, the investor needs to establish trading relationships with a broker-dealer and/or market maker, who will provide account settlement instructions to book and settle individual trades.
How to Choose a Trading Venue The decision on how to trade should be based on your execution priorities, including speed of execution, anonymity, market impact and cost. A key consideration for whether to trade on an exchange or OTC is the size of the trade. As with trades of individual stocks, larger trades that exceed average daily volume require greater care, meaning it’s often better to work with a broker-dealer or market maker over the counter. If the trade size is typical in the underlying market, it generally should be acceptable in an ETF.
Capital markets teams can serve as a valuable resource for guidance on liquidity. These professionals are in tune with the markets and have robust relationships with liquidity providers. Also, they can discuss optimal trading strategies for a specific ETF, the underlying market, the size of the trade and, most important, your trading priorities.
Pricing ETF pricing is dynamic. A fixed income ETF’s price should be driven by the sum of the value of the underlying bonds throughout the day (NAV), combined with supply and demand factors (heavy buying/selling) that may move the ETF price higher or lower at any given moment. Liquidity providers are incentivized to keep ETF pricing in line with its underlying constituent pricing by arbitraging out any excess premiums/discounts.
The creation and redemption of ETF shares on the primary market provides an opportunity to keep share prices in line with the NAV of the underlying securities. It enables market makers to offer liquidity that is not otherwise available on the exchange. This is done by delivering underlying securities in exchange for new shares, which can then be sold to the investor.
Funds construct their NAV based on transparent components, such as principal, interest, cash and accrued interest/undistributed income. ETF issuers publish daily reports that include all of these components so that anyone can calculate a fair price for the ETF. Nevertheless, pricing remains dynamic because it depends on factors in place at the time of the trade. As a result, the price paid for an ETF share on the secondary market can easily differ from the latest published NAV price. As detailed below, pricing that deviates from NAV can be a good thing.
The possibility that an ETF’s share price may deviate from the NAV may cause concern. Yet, an ETF price deviating from its underlying NAV is more of a window into what is happening in the underlying market rather than a product drawback.
For example, in the middle of March 2020, the average discount on fixed income ETFs across the industry widened to levels unseen since the Global Financial Crisis (GFC). Those discounts made sense, because ETFs were being used as price discovery tools. The discount simply reflected the fair market price between willing buyers and sellers based on their assessments of the valuation of the underlying bonds, macroeconomic factors and liquidity. It’s important to note that, at the time, some of those bonds may not have traded recently.
At its most basic level, an ETF’s NAV reflects an estimate of the value of the fund’s underlying portfolio based on the pricing of the underlying securities. Typically, that NAV is a fairly accurate number.
However, in a volatile market — such as in the spring of 2020 — difficulties in pricing and trading fixed income securities affected the estimate of the fair value of a basket of bonds. When underlying fixed income market liquidity becomes constrained, pricing becomes increasingly opaque as the number of bond trades declines. In those situations, individual bond pricing can lag real-time market sentiment and executable pricing.
ETF share prices at any given time reflect real-time sentiment: The price at which they trade is the price the market says the basket of bonds they represent is worth, accounting for current macroeconomic information and risk assessments. ETF shares that trade at a discount signal that market dynamics have gotten ahead of the intrinsic value of the underlying securities as measured by the NAV.
It’s also worth noting that structural factors can produce wider-than-normal premiums and discounts during periods of volatility. Fixed income NAV prices are typically struck as of 3 p.m. EST, but ETFs continue to trade until 4 p.m. In March 2020, much market-moving news broke well after 3 p.m., producing deviations from NAV, as the market incorporated real-time news while the underlying market was closed. Again, this scenario demonstrated ETFs’ ability to act as a price-discovery tool and heighten the need to analyze the most productive trading strategy to optimize buy and sell orders.
Depository Trust Company (DTC) One of the world’s largest securities depositories. It also acts as a clearinghouse to process and settle trades in corporate and municipal securities.
Net Asset Value (NAV) The calculated assets minus liabilities divided by shares outstanding. NAV is the straightforward account of the actual assets in the fund.
Over-The-Counter, or OTC A term in financial markets used to describe transactions that occur away from any listed exchanges between individuals or involving dealer networks, whether in stock, bond, currency or derivatives markets.
Premium and Discount If an ETF is trading above its NAV, the ETF is said to be trading at a premium. If the price of the ETF is trading below its NAV, the ETF is said to be trading at a discount.
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