Underlying Bond Return Predictability by ETF Returns

Abstract

This paper investigates whether ETF returns lead the returns of underlying bonds and similar style bond funds. Bond prices are often stale due to their lack of liquidity, and price discovery may occur in ETFs and then in underlying bonds. As predicted, we find that ETF returns predict its own NAV returns and aggregated ETF returns for each bond also predict the underlying bond returns on a monthly basis. We show that bond liquidity is the determining factor of the predictability and the role of authorized participants is critical to the dissemination of information from ETFs to underlying bonds. Bond returns are more predictable for illiquid bonds and bonds with less ETF ownership and less absolute ETF flows. Next, we examine whether bond fund returns are also predictable. We find the predictability of bond fund returns by same style ETF returns and a bond fund portfolio strategy based on this predictability, which indicates that the bond fund market is potentially vulnerable. Our research adds to the discussion of the impact of ETFs on market efficiency.