ETFs, illiquid assets, and fire sales

Summary

Focus

Bond exchange-traded funds (ETFs) have grown steadily over the past decade and as of early 2021 managed more than $1.2 trillion. We illustrate that the specifics of the bond market lead to different arbitrage mechanics of bond ETFs relative to traditionally studied equity ETFs. Bond ETF baskets (the set of assets used to create or redeem ETF shares) contain a small fraction of holdings – a fact we refer to as "fractional baskets". This fact challenges the common assumption that baskets are representative of holdings, and has important implications for the ETF arbitrage process. We argue that fractional baskets may be a feature of ETFs holding illiquid assets since they create a buffer between the ETF market and the underlying bond market. We also show that ETFs can avoid fire sales through the action of authorised participants.

Contribution

Our paper makes three contributions. First, we introduce a new methodology to infer baskets. Second, we show that baskets are only a fraction of holdings, which makes the arbitrage mechanism of bond ETFs different from that of equity ETFs. We illustrate that fractional baskets can create persistent ETF premia and discounts. This finding suggests that volatility effects associated with arbitrage trading in equity ETFs, and documented in previous studies, may be muted in bond ETFs. Third, we argue that fractional baskets for ETFs holding illiquid bonds can be beneficial at times of stress by allowing authorised participants to act as a buffer and prevent fire sales.

Findings

We document several new facts. First, we find that roughly 10% of holdings are in creation baskets and 20% are in redemption baskets for ETFs holding corporate bonds. This is in stark contrast to ETFs holding equities and Treasuries, where ETF baskets are close to 100% of holdings. Second, corporate bond ETFs' baskets have high turnover. Third, we find that creation (redemption) baskets tend to have longer (shorter) durations and smaller (larger) bid-ask spreads relative to holdings. Finally, we develop a model which shows that ETFs may be more effective at managing illiquid assets than mutual funds.

Abstract

We document several novel facts about exchange-traded funds (ETFs) holding corporate bonds. First, the portfolio of bonds that are exchanged for new or existing ETF shares (called creation or redemption baskets) often represents a small fraction of ETF holdings – a fact that we call "fractional baskets." Second, creation and redemption baskets exhibit high turnover. Third, creation (redemption) baskets tend to have longer (shorter) durations and smaller (larger) bid-ask spreads relative to holdings. Lastly, ETFs with fractional baskets exhibit persistent premiums and discounts, which is related to the slow adjustment of NAV returns to ETF returns. We develop a simple model to show that an ETF's authorized participants (APs) can act as a buffer between the ETF market and the underlying illiquid assets, and help mitigate fire sales. Our findings suggest that ETFs may be more effective in managing illiquid assets than mutual funds.

Keywords: bonds, ETFs, fire sales, liquidity.

JEL classification: G01, G11, G12, G23.