By Alex Evangeli
The ecosystem that powers fixed income ETF trading is more complex than the simplicity of trading the product suggests. Behind the scenes, liquidity providers manage large ETF positions through the primary market, a process that requires expertise and resources. As investors educate themselves on the mechanics of fixed income ETF trading, they will discover that the primary market can be used as a tool to convert bond portfolios into ETF shares efficiently.
The primary market and associated challenges
The primary market is where ETF units are added and removed from circulation. In order to create or redeem a fixed income ETF, a transaction can take place vs bonds (called in-kind) or vs cash.
Arbitrageurs bring ETFs back to a fair valuation in the secondary market. Positions can be collapsed in the primary market, where an ETF can be exchanged vs official valuation; the Net Asset Value.
When liquidity providers transact in-kind, issuers retain ultimate discretion over the exact composition of the creation or redemption basket they accept, yet they are bound by the fund’s mandate detailed in the prospectus. This flexibility opens the door for custom basket negotiation, allowing a liquidity provider to propose tailored asset lists that align with both the fund’s parameters and their own desired positioning.
Constructing an optimal in-kind basket requires a trader to weigh numerous competing constraints simultaneously. The trader must adhere to the index composition considering factors such as duration, credit, issuer, sector exposure, while concurrently evaluating internal buy/sell signals. While the broad mechanics of creation and redemption are consistent across ETF providers, the specific procedures including negotiation process, fund preferences, cut-off times, and settlement conventions differ. A liquidity provider working across multiple ETF providers and regions must manage multiple frameworks simultaneously which requires traders with significant expertise.
In recent years, some ETF providers have tightened their in-kind primary market processes via automated, algorithm driven basket screening systems. This has resulted in more stringent enforcement of basket diversification. Stricter diversification standards complicate inventory management for the liquidity provider. The tails of a basket, which consist of off-the-run treasuries or illiquid corporates, carry inventory risk; particularly in volatile rate environments.
How understanding the primary market helps an investor
For active managers looking to increase ETF allocation without the cost of a conventional liquidation and repurchase, portfolio trading vs ETFs deserves consideration.
The case for using ETFs is particularly compelling during periods of market stress. When liquidity in the underlying bond market deteriorates, fixed income ETFs can trade with tighter spreads and more size than individual bonds. A manager who has pre-emptively converted aportion of their portfolio into ETFs is better positioned to respond quickly when redemption pressure or reallocation needs arise. Rather than trying to find liquidity bond by bond, an ETF can be moved quickly, in size.
One approach could involve an active manager constructing, with knowledge of the ETF composition, a diversified basket of bonds from an existing portfolio. This can be traded as a portfolio directly vs an ETF via a liquidity provider, converting bond exposure into ETF shares. The liquidity provider will assess, in the context of existing risk, which bonds to suggest to the issuer for the ETF creation, keeping transaction costs low.
There is, however, no guarantee the portfolio will be accepted by an ETF issuer, and inventory risk remains for the liquidity provider, who will price accordingly.
Summary
For those managing larger bond portfolios, understanding the primary market and portfolio trading process opens a lower-cost pathway into fixed income ETF exposure compared with individual secondary market transitions. In times of stress, holding ETFs could help mitigate liquidity issues when the need to transact arises. Engaging with a well-equipped liquidity provider is useful for investors learning about fixed income ETF trading and achieving their desired execution outcome.
Disclaimer: Views are my own. This is for informational purposes only and should not be relied upon to make investment decisions.
Biography: Alex Evangeli, an experienced voice in ETF market making, has traded the product since 2007. Alex founded and led the fixed income trading business in Europe at Virtu Financial before relocating to New York to trade and lead the development of fixed income trading technology for the firm’s ETF block business. Previously, he held senior positions at Brownstone Investment Group and Cantor Fitzgerald where he was deeply involved in fixed income ETF and cash bond risk trading.
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