Fixed-Income ETFs: A liquidity illusion?

Abstract

Exchange-Traded Funds (ETFs) have revolutionised the asset-management industry with high liquidity and low bid-asks allowing investors to access a diversified portfolio cheaply. The desirable liquidity characteristics of ETFs are, however, in contrast with their behavior in crisis periods. This paper studies the breakdown in the fixed-income ETFs (FIETFs) market, during the peak of the COVID-19-driven liquidity shock of March 2020. We argue that FIETFs provide an illusion of liquidity and the liquidity mismatch between the ETF and the underlying manifests itself in terms of very significant differences between the price and the Net Asset Value (NAV). We run a further analysis on the dislocation by comparing it with equity ETFs. Comparisons suggest that the cost of liquidity is very high for fixed-income ETFs with significant tracking errors during volatile periods in contrast with the better-behaved equity ETFs. Further analysis on the performance patterns of FIETFs indicates that both the price and NAV might have deviated from fundamentals with an overreaction in the ETF price accompanying an underreaction in the NAV. We also study the phenomena of ‘dealer inventory management’. FIETFs are uniquely different from equity ETFs in that the authorised participant (arbitrageurs) tend to be the large banks that are also market-makers in the underlying securities. Therefore, we show that the incentives of the arbitrageurs may not always be aligned towards arbitraging the price-NAV differential. In a novel empirical study using trading volumes and position changes for the largest corporate bond ETF (LQD), we suggest that inventory management by the larger broker-dealers may have exacerbated the dislocation. We believe that the conflicting objectives of dealers have further increased due to high balance-sheet costs imposed upon them post the Global Financial Crisis. Finally, we propose the use of derivatives, in particular credit derivatives, for the risk management of liquidity shocks. We show that the drawdown from rapid liquidity shocks can be reduced significantly through exposure to credit convexity.