The Two Sides of the Corporate Bond ETF Liquidity Transformation

Abstract

Most ETF trading occurs in secondary markets. Comparing two bonds from the same issuer, greater exposure to ETF exchange trading increases the comovement of bond returns by lowering idiosyncratic risk. Constituency in liquid ETFs mitigates the increased idiosyncratic risk from higher ETF ownership in low systematic noise periods. The impact of liquid ETFs is attributed to their use by insurance companies to address liquidity needs and to faster incorporation of market‐wide news. In periods of heightened systematic noise, greater ETF secondary market exposure increases idiosyncratic and systematic risk. There is no evidence ETFs negatively affect price discovery around issuer‐level downgrades.

Keywords: ETF, corporate bonds, comovement, secondary trading, risk

JEL Classification: G12, G14, D47