Fixed Income ETFs are portfolios of cash bonds that trade on an equity exchange. In this way, fixed Income ETFs offer the ease of trading of a stock with the diversification benefit of a portfolio of bonds.
How Fixed Income ETFs are Created
The supply of fixed income ETF shares on an equity exchange is determined by a unique mechanism called the creation/redemption process.
- iShares partners with broker-dealers who help maintain ETF liquidity in the market and facilitate the process of creating or redeeming shares of ETFs.
- When an investor wants to buy an ETF, a broker/dealer can fill the order with its available inventory. Buying shares of the ETF often results in lower spread and impact costs for the investor versus buying the individual bonds themselves.
- If the broker/dealer does not have any ETF inventory, it can purchase the bonds that make up the ETF in the OTC market and exchange them with BlackRock for new ETF shares.
- The broker/dealer will then deliver the ETF shares to fill the investor’s order.
Fixed Income ETF Price Behavior and NAV
The price at which an ETF trades is primarily a function of the value of the underlying securities in the portfolio. It is also influenced by market flows, liquidity, and market volatility.
- The net asset value (NAV) of an ETF is equal to the total fund assets divided by the total shares outstanding.
- When an ETF trades at a price above the NAV, it is said to be trading at a premium; when the ETF is trading below the NAV, it is said to be trading at a discount.
- The market price of the ETF will generally fluctuate between the bid and offer price of the underlying bonds as the fund trades through the day.
- The creation of ETF shares helps balance supply and demand, which brings the NAV and the ETF price into alignment.
Comparing and Translating Fixed Income ETF Price Quotes
Bond market participants quote securities in a variety of ways, including using dollar prices, yields, and spreads.
- Fixed income ETFs are exchange traded and quoted in price terms like equity securities.
- The graphic to the right provides a framework for the interpretation and comparison of bond and fixed income ETF quotes.
Fixed Income ETF Management and Rebalancing Process
The primary goal of an Index ETF is to track the fund’s designated benchmark. The portfolio management process is ongoing process that attempts to balance tracking error and transaction costs.
- Most fixed income ETFs are constructed through sampling, which means that the ETF holds a subset of securities that together best track the benchmark index.
- An ETF that is sampled can help reduce the transactional costs necessary to keep the ETF tracking its index.
- On a monthly basis, most fixed income ETFs are rebalanced to take into account cash flows and underlying benchmark changes.
- The rebalancing process accounts for new issuance, maturities, bonds no longer in the maturity range, calls or refinancing, defaults, and downgrades or upgrades.