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ETFs Help Add Liquidity to an Otherwise Illiquid Bond Market

This article was originally published on ETFTrends.com.

A myth of exchange-traded funds is that the constant buying and selling could result in inflated stock prices that don’t reflect the true valuation of a particular company. While this is an ongoing debate in the equities market, others view that in the bond market, ETFs are actually a purveyor of liquidity where constant buying and selling is a good thing.

This is particularly true in the current environment where investors are snatching up bonds to seek refuge from the volatility in equities. With everyone buying bonds, ETFs can help infuse liquidity.

“ETFs--particularly those investing in high-yield bonds and bank loans--have been singled out as an area of specific alarm, given their unique structure and perceived superior liquidity,” said Ben Johnson in a Morningstar article. “Some of these fears could prove to be perfectly reasonable, though most of them aren't unique to ETFs,” said  The ETF-specific concerns serve as evidence that many investors still don't fully comprehend the function fixed-income ETFs serve or how they work.”

Johnson made the distinction between how liquidity is affected in bonds versus stocks.

“Bonds are not stocks. Bonds are often bought with the intention of being held until maturity,” said Johnson. “Thus, they are traded far less frequently than stocks. Also, there is no central exchange for bonds as there is for stocks. Bonds are traded over the counter. Buyers and sellers may link up over the phone or via instant messaging. The process can be time-consuming and expensive. Additionally, bonds are not standardized. Citigroup's stock has a single listing, but the firm has more than 1,000 different bonds, each of them unique. This fragmentation further fosters illiquidity.”

“Liquidity also varies depending upon prevailing market conditions,” Johnson added. “In good times, it is plentiful and inexpensive. In bad times, it is hard to come by and costly.”

Liquidity Varies

Investors looking to get core bond exposure can look to funds like the iShares Core U.S. Aggregate Bond ETF (AGG) .

Fund Facts:

  • AGG seeks to track the investment results of the Bloomberg Barclays U.S. Aggregate Bond Index.
  • The index measures the performance of the total U.S. investment-grade bond market.
  • The fund generally invests at least 90% of its net assets in component securities of its underlying index and in investments that have economic characteristics that are substantially identical to the economic characteristics of the component securities of its underlying index.

Reasons to use AGG:

  • Broad exposure to U.S. investment-grade bonds
  • A low-cost easy way to diversify a portfolio using fixed income
  • Use at the core of your portfolio to seek stability and pursue income

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