But there's an added nuance to the ETFs that plays to the liquidity dynamics of the corporate bond market. Unlike equity ETFs, where creation/redemption baskets tend to fully replicate the underlying holdings, bond ETF baskets are built to smooth liquidity, either with round lots of liquid securities or customized baskets within the bounds of the ETF's investment goals and risk metrics.
An ETF holding 1,000 CUSIPs might only create and redeem using 60 or 70 specific issues. In this light, ETFs overall are no more or less susceptible to the whims of the market than other holders of less liquid securities, including traditional mutual funds and institutional investors.
The intraday ETF market price, however, can serve as a feedback loop for trading individual securities in an index to the extent that markets lock up and investors are searching for a clearing price.
“Underlying bonds inside ETFs tend to trade tighter” than those not eligible for an index, says Reginald M. Browne, senior managing director at Cantor Fitzgerald LP in New York. Mr. Browne and other ETF market-makers must make daily assessments of both the ETF basket as well as the fully disclosed underlying holdings to the extent that some of those securities may appear in future baskets.
Additionally, those looking to transact in individual issues held by the ETF can also find where the asset manager is marking those securities through their daily holdings disclosure and NAV. “For institutions, this can be another input in their pricing for plain-vanilla corporates,” said Pierre Robert, founder and CEO of Best Credit Data Inc. in Concord, Mass.
TABB's Mr. Perrotta in an interview said the “real downside risk scenario is not so much how the ETF prices, but what exactly is the imbalance between asset owners looking to transact and liquidity providers willing to make a market.” Generally, the cost of liquidity in the underlying holdings, individually and in aggregate, provides the upper and lower bound for ETF trading spreads. “The cash market will ultimately be the guardrail for the ETF price,” said David Krein, head of research for MarketAxess Holdings Inc. in New York.
When those “arbitrage bands” are reached, market-makers and authorized participants would generally create or redeem shares and buy or sell the underlying securities to capture the arbitrage and collapse the spread. In choppier markets for the underlying securities trading spreads can widen out for the ETF itself and the market price may sustain greater premiums or discounts to the NAV.