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ETFs, Creation and Redemption Processes, and Bond Liquidity

Published online by Cambridge University Press:  22 April 2024

John D. Finnerty Open the ORCID record for John D. Finnerty [Opens in a new window] ,
Natalia Reisel Open the ORCID record for Natalia Reisel [Opens in a new window]  and
Xun Zhong
John D. Finnerty*
Affiliation:
Fordham University Gabelli School of Business
Natalia Reisel
Affiliation:
Fordham University Gabelli School of Business [email protected]
Xun Zhong
Affiliation:
Fordham University Gabelli School of Business [email protected]
*
[email protected] (corresponding author)
Rights & Permissions [Opens in a new window]

Abstract

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We examine a link between bond exchange-traded fund (ETF) creation and redemption processes and the underlying bond market liquidity. Using daily creation and redemption data, we find that including a bond in a creation or redemption basket has a favorable impact on the bond’s liquidity for both high-yield and investment-grade markets. The improvement in liquidity persists during times of market stress with this impact being stronger for redemptions than creations. Our results suggest that ETF mispricing arbitrage explains the improvement in bond liquidity. However, we also find evidence that transaction costs and bond inventory management limit the ETF arbitrage.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , First View , pp. 1 - 34
Copyright
© The Author(s), 2024. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

The authors thank Doug Blackburn, Steve Laipply, Ananth Madhavan, Josh Penzner, and Kumar Venkataraman for many valuable insights. We thank Christopher Reilly (the referee) and Jennifer Conrad (the editor) for their detailed helpful comments. We are responsible for any remaining errors.

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