Bond ETF, Mispricing, and Divergence of Interests

Project: Research

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Bond exchange-traded funds (ETFs) invest in fixed-income securities such as corporate bonds. The bond ETF market has developed substantially over the last decade. By 2020, the total net assets of bond ETFs reached over US$1 trillion. The ETF share prices are kept close to the net asset value (NAV) of the holdings via an arbitrage mechanism, which requires authorized participants (APs) to create or redeem ETF shares. APs will deliver a creation basket containing underlying assets and receive new ETF shares from the ETF manager (sponsor) when the share price is above NAV. Similarly, APs exchange ETF shares for a redemption basket of underlying securities when the price is below NAV. The extant literature primarily focuses on equity ETFs and studies the impacts of equity ETFs on underlying stocks' liquidity, mispricing, etc. This proposal investigates implications from a crucial distinction between bond and equity ETFs – the nature of creation/redemption baskets. The baskets for equity ETFs are almost identical to holdings. However, for bond ETFs, the baskets differ from the actual holdings due to the illiquidity of bonds (Todorov, 2021). Moreover, creation and redemption baskets often contain different bonds. We propose that the discrepancy in liquidity between creation and redemption baskets reflects the conflicts between APs and ETF sponsors, which can limit arbitrage activities. APs are usually large market makers and this dual role could prevent them from closing the arbitrage gap. For example, APs may redeem ETF shares when they have extremely negative bond inventory imbalances and demand more bonds to satisfy their marketmaking needs while they should have created shares in this scenario. In response, the sponsor could include more liquid and longer maturity bonds in the creation basket and illiquid and shorter duration bonds in the redemption basket to prevent further strengthening the mispricing. Since conflicts between ETF sponsors and APs affect arbitrage activities and thus ETF pricing, we argue that a factor model that takes into account such conflicts can explain ETF return anomalies.This project will establish an important link between mispricing and the roles of ETF stakeholders. It will enrich the understanding of how market frictions affect asset pricing. Finally, it will guide the policymakers to examine the impact of new investment vehicles on the underlying securities


Project number9043641
Grant typeGRF
StatusNot started
Effective start/end date1/01/24 → …