The Hidden Cost of Corporate Bond ETFs

Abstract

I document a hidden but substantial cost associated with the liquidity transformation that corporate bond exchange-traded funds (ETFs) provide. When creating new shares, authorized participants (APs) deliver a subset of the portfolio of bonds that underlie a corporate bond ETF. This subset contains bonds that realize low future returns, reducing ETF performance by 48 basis points per annum. This loss in performance cannot be attributed to forgone compensation for risk or illiquidity, but instead results from APs utilizing information regarding future changes in bond values to strategically deliver bonds when those bonds are expected to realize poor performance in the near future.

Keywords: ETFs, corporate bonds, liquidity transformation

JEL Classification: G12, G23