Valuation and Liquidity of Fixed Income ETFs

Bond markets have long been fragmented, opaque and relationship dependent.

By packaging a diversified bond portfolio into an exchange listed product, fixed income ETFs provide investors something the underlying market does not offer in combination: price transparency, significant intraday liquidity and operational simplicity.

The ease of trading this package is not by chance. Issuers and liquidity providers (banks and market makers) deal with the complexity of such a seemingly simple product. Investors however, can gain exposure in a single click.

Fixed income ETFs have many uses, such as cash management, benchmark replication, hedging, speculation and transition management. Trading them well, especially in size, requires expertise. Understanding valuation and liquidity, which both carry nuances specific to fixed income markets, is key.

Valuation

Portfolio composition files (PCFs) are published daily by ETF issuers. Liquidity providers use these files to calculate live ETF valuations. PCFs contain information including the projected cash for today, component weights and the divisor (used to divide the fund into shares, so a value per share can be calculated). They can be obtained directly from ETF issuers or via third-party companies that extract and standardise this data – which is a time-consuming process.

Liquidity providers combine PCFs with their best estimate of bond prices to calculate fair values (FVs) of fixed income ETFs.

Estimating bond prices is a challenge. In the US, TRACE provides post-trade transparency for OTC bond transactions. In Europe, equivalent data remains fragmented across multiple sources, though the forthcoming consolidated tape should address this in time. However, most bonds do not trade actively on a centralised exchange and many do not trade on a given day.

Liquidity providers will often use at least one third-party bond valuation source to ascertain bond prices and spreads for bonds within the PCF. More sophisticated liquidity providers might adjust bond prices themselves and also stream their own internal bond valuation into the PCF.

An investor has two main options to ascertain fixed income ETF valuations:

• Build their own fair value system using PCFs and live bond prices. This, however, requires considerable expertise and effort to generate a consistently, scalable, accurate output.

• Consume an indicative valuation ‘iNAV’ from a third party. There are various data providers that offer this service. iNAV often provides a general indication of where ETFs are trading yet should not be relied upon solely to make investment decisions.

Armed with this data, institutional investors can assess relative value between ETFs and underlying markets and increase the quality of execution. For example, what is the most efficient method to access bond exposure today? It could be via individual cash bonds, ETFs or a portfolio trade.

Assessing Liquidity

One misconception is that average daily volume (ADV) is the primary metric of fixed income ETF liquidity. This often limits the short-term asset growth of newly issued ETFs when it should not. In Europe, given exchange fragmentation, this problem is magnified compared to the United States where volume data is consolidated.

Critically, fixed income ETF liquidity is created by liquidity providers who transact off exchange in an over-the-counter fashion. The primary market is the trusted pathway to add and remove shares from circulation. Liquidity providers can create and redeem shares in significant size and this is critical in understanding why an ETF that trades little on exchange could be extremely liquid.

Liquidity is not unlimited. Fixed income ETFs contain a basket of bonds. The liquidity profile of these bonds should be considered when assessing the liquidity of the actual ETF. Liquidity providers are aware of this when pricing for clients and the same awareness should extend to investors when making significant investment decisions. There are many great products issued in both Europe and the United States with low assets which suffer from misunderstandings of liquidity.

There are a number of factors investors can use to ascertain the liquidity of a fixed income ETF:

• Liquidity of the underlying basket.

• Amount outstanding of the underlying basket.

• Number of liquidity providers that price the product competitively via RFQ.

• Of these liquidity providers who price the product: the number of liquidity providers who have access to create/redeem that product. In Europe, the actual number of authorised participants is important and varies considerably by issuer. In the United States, the number of liquidity providers who are either an authorised participant or can place create/redeem orders via their prime broker should be considered.

• Consolidated ADV including block trades. In Europe, this should be combined across all fully fungible listings and the forthcoming consolidated ETF tape will help immensely. In the United States, we do not assess ETF liquidity based upon just ARCA and NYSE; the volume is already consolidated across all exchanges to help build a picture of liquidity.

All the above data is relatively simple to obtain via issuers, third party data providers or self-calculation using standard data sources. The technology exists today to create an accurate internal measure of liquidity which does not rely solely on ADV.

Summary

Fixed income ETFs are now core portfolio tools. Issuers and liquidity providers handle the complexity of these products, but investors who have some understanding of both valuation and liquidity are better placed to execute efficiently.