Fixed income exchange traded funds (ETFs) are transforming the traditionally fragmented and opaque fixed income marketplace. This paper highlights how developments in fixed income ETF trading are providing users with additive liquidity benefits and implementation flexibility.
The first fixed income ETF was launched in 2002 and, given robust demand for a diversified and tradeable instrument with hyper-transparency, assets under management for US-listed fixed income ETFs recently surpassed $1.2T.1 Many consider the 2008 financial crisis to be a central catalyst in fixed income ETFs’ growth. Driven by the tighter post-crisis regulatory environment, the shifting market structure of secondary fixed income trading has helped to steer investors toward additional sources of liquidity. These dynamics, combined with progress toward electronic trading, led many banks to transition from a principal-based dealer to an agency trading model in underlying bond markets.
The COVID crisis of 2020 further reinforced fixed income ETFs’ importance in the investing universe. On March 23, 2020, to support credit to employers by providing liquidity to the market for outstanding corporate bonds, the Federal Reserve established the Secondary Market Corporate Credit Facility, which purchased investment-grade bonds as well as corporate bond ETFs. ETFs were likely added to the program as a result of their ease of trade, price transparency, and their holding of many different underlying bond issuers.
Corporate Bond Market Developments
The US corporate bond segment has contributed significantly to overall ETF asset and liquidity growth. This segment of the bond market relies heavily on principal-based market making services. As dealer bond inventories have declined from regulatory initiatives and overall corporate bond issuance has varied dramatically over time, corporate bond ETFs have experienced significant increases in secondary trading. This progress can be attributed to a broadening client user base, where virtually all client types in the institutional and retail spaces are now using fixed income ETFs. Additionally, greater focus on inventory management and market making services, integration of fixed income ETFs as a derivative alternative and technological advancements from the sell-side have also contributed. Developments in corporate bond ETF trading are evident in the secondary trading profile of the SPDR Bloomberg Barclays High Yield Bond ETF (JNK). As illustrated in Figure 1, JNK’s average annual premium and discount volatility has declined over the last 10+ years. Given these dynamics, JNK’s continuous market price has become a price discovery tool for the underlying constituents.
Source: Bloomberg Finance L.P. As of 07/30/2021.
What Is Additive Liquidity?
The desire for a centralized marketplace and price transparency offered through exchange trading becomes particularly pronounced during periods of market stress. In these environments, the highly fragmented nature of the traditional fixed income market structure makes it difficult to source liquidity as dealers may be less willing to commit capital — at exactly the time when investors need it most. Amid this uncertainty, investors have gravitated away from attempting to trade many individual corporate bond line items and leaving open orders (with low confidence of execution) on what they cannot sell immediately, and toward the ETF as a dependable source of liquidity.
As illustrated in Figure 2, JNK has experienced significant increases in secondary trading volume during periods of higher relative volatility. The volume spikes can be contextualized by comparing the notional value traded to that of the underlying bonds. The ratio of secondary to primary trading increases as the ETF is used as a preferred vehicle to transfer risk during these periods. JNK secondary market value traded has averaged roughly 15.9% of the underlying high yield bond dollar volumes over the previous five year period, but that percentage historically increases to 30–
40% during times of market stress.2
Figure 2: JNK Primary and Secondary Activity
In addition to providing an alternative source of liquidity from traditional over-the-counter (OTC) markets, ETFs provide an efficient wrapper in which secondary market trading may provide transactional cost efficiency relative to trading the underlying basket of bonds. As outlined below, spreads for high yield ETFs are significantly tighter than the implied spreads of the underlying bonds based on Index Liquidity Cost Scores (LCS).
Source: ETF Spread - NYSE as of 8/31/2021; ETF Basket Spread - Bloomberg and State Street Global Advisors as of 9/3/21. 30-day ETF bid/ask spread as of 8/31/2021. 40-day market value weighted bid/ask spread of ETF holdings as of 9/3/2021. “Institutional size” defined as $50mm for SJNK, JNK, SPIB, SPLB, CWB. As represented by the Barclays Liquidity Cost Score (LCS) metric for the respective index. There can be no assurance that a liquid market will be maintained for ETF shares.
Net Asset Value (NAV) and Premium/Discount
As a result of the dynamics of fixed income pricing, bond-based ETFs generally trade at a premium to Net Asset Value (NAV). The reason for this is that the ETF NAV is prices on the BID side of the market, and the secondary market liquidity will bring spreads in tighter on both sides of the market. Fixed income premiums or discounts may reflect market sentiment as well as the liquidity risk market makers face to buy or sell the underlying cash bonds. This dynamic is frequently highlighted during fear-driven market environments in which the typical ETF premium may diminish or potentially result in the fund trading at a discount to NAV.
Trading Support from State Street Global Advisors
In the first two quarters of 2021, $17.4B has traded notionally on a daily basis in the US-listed fixed income ETF space.3 Growth in secondary trading volume has enabled the ETF to be used as a tool to express many types of trading styles and priorities. Execution strategy decisions should take into consideration both primary market implied basket liquidity and secondary market ETF trading profile.
Our Sales Execution and Implementation and Capital Markets teams offer trading education and support for a range of strategies, including:
Low-Touch Trading Strategies
ETFs, as equity securities, can be traded using low-touch strategies with potentially enhanced measurable execution results. Popular algorithmic equity execution strategies are available to fixed income investors including strategies benchmarked to the Time Weighted Average Price (TWAP) or the Volume Weighted Average Price (VWAP) in which investors can target execution participation strategies based on windows in time or alongside volume measured participation, respectively. In addition to these relatively common and straightforward strategies, there are a plethora of other algorithmic trading strategies available to investors across providers.
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.
Other Trading Benchmarks
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. Additionally, more commonly utilized equity order types of Market-On-Open (MOO) or Market-On-Close (MOC) offer easily measurable execution targets based on the opening or closing US ETF market price; however, we recommend caution using these order types when trading ETFs as the market for MOO/MOC orders for the ETF may differ dramatically than that of the underlying securities and NAV calculations.
Transfer of Assets
Large institutional owners of underlying bonds have utilized the in-kind creation and redemption features of the ETF to exchange bonds for ETF shares. The exchange of bonds for ETF shares may help avoid associated transaction costs of selling the individual bonds by offering access to secondary market ETF trading. Additionally, an ETF offers an operational ease of use through a passively managed exposure in a single line item instead of multiple bonds. We also see demand for this amongst transition managers who seek to move bonds from legacy portfolios to target portfolios. Paying full bid/ask spreads for these transitions can be very costly, and the ETF create/redeem mechanism is optimal for a less expensive conversion.
OTC Derivative Alternative
ETF options and securities lending markets have developed on many of the most liquid ETFs. The flexibility of the ETF wrapper and associated products supports usage as an efficient alternative to other derivative products. There has also been continued growth in relative value trading as investors compare fixed income ETFs to other vehicles.
Looking Ahead: Increased Liquidity and Flexibility
The centralized and transparent exchange trading versus the fragmented and opaque bond trading environment offers real-time and continuous pricing during US equity market trading hours. Developments in secondary ETF trading profiles provide investors spreads that may be tighter than the underlying basket of securities — resulting in transaction cost savings. The centralized exchange trading of the ETF wrapper attracts significant activity in times of uncertainty as fixed income investors utilize the ETF as a source of additive liquidity.
Finally, the ETF has dramatically expanded implementation flexibility for traditional fixed income investors. In addition to the ability to access equity order type management options, new and innovative uses of the ETF wrapper continue to gain traction. All of this activity builds a stronger ETF ecosystem that ultimately delivers trading efficiency benefits to all investors.
About SPDR Sales Execution and Implementation and Capital Markets Teams
We are responsible for building relationships with SPDR ETF authorized participants, market makers, liquidity providers, execution trading desks/platforms and stock exchanges. Our team plays an active role in promoting competitive markets and maintaining the SPDR ETF liquidity ecosystem.
Given our insight into primary and secondary market activity as well as our access to a wide variety of pre-trade liquidity analytics tools, the SPDR Capital Markets team is dedicated to working closely with clients to help educate them about the nuances of ETF execution and ultimately ensure they are equipped with the knowledge necessary to most effectively trade SPDR ETFs.
Learn More Please contact us with any questions regarding ETF liquidity and execution at USSPDR-SEI@ssga.com
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1 Bloomberg Finance, L.P., as of 06/30/2021. 2 Bloomberg Finance L.P. As of 08/31/2021. It is also worth highlighting that new financial market regulation has been centered on liquidity stressed markets. One example of this is the “Liquidity Rule” for open-end funds registered under the Investment Company Act of 1940. ETFs may provide a liquidity enhancement tool for other open-end funds to comply with this new regulation and lead to further usage during these periods. 3 Bloomberg Finance, L.P., as of 06/30/2021.
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There can be no assurance that a liquid market will be maintained for ETF shares
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