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ETF Specialist

Bond Market Liquidity and the ETF Bogeyman

Many investors still don’t fully comprehend the function that fixed-income ETFs serve or how they work.

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The specter of rising interest rates has brought the topic of bond market liquidity to the fore. Over the past decade, assets in fixed-income mutual funds and exchange-traded funds have more than tripled while traditional liquidity providers' role in bond markets has greatly diminished and trading volumes have shriveled. These opposing trends have fueled concerns that higher rates could result in mass selling into a market that appears ill-prepared to deal with a rush to the exits.

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. Some of these fears could prove to be perfectly reasonable--though most of them aren't unique to ETFs. The ETF-specific concerns serve as evidence that many investors still don't fully comprehend the function that fixed-income ETFs serve or how they work.

Ben Johnson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.