Exchange-traded funds (ETFs) allow a wide range of investors to gain exposure to a variety of asset classes. They rely on authorised participants (APs) to perform arbitrage, ie align ETFs’ share prices with the value of the underlying asset holdings. For bond ETFs, prominent albeit understudied features of the arbitrage mechanism are systematic differences between the baskets of bonds used to create and redeem ETF shares, and a low overlap between these baskets and actual asset holdings. These features could reflect the illiquid nature of bond trading, ETFs’ portfolio management and APs’ incentives. The decoupling of baskets from holdings weakens arbitrage forces but allows ETFs to absorb shocks on the bond market.
- Bond exchange-traded funds (ETFs) have grown to manage more than $1.2 trillion of assets globally.
- The arbitrage mechanism, which keeps bond ETF prices aligned with the value of the underlying investments, operates differently from that of equity ETFs.
- This difference potentially makes it harder for investors to exploit price gaps but allows bond ETFs to absorb shocks and withstand market stress.
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