ETFs, Creation and Redemption Processes, and Bond Liquidity

John D. Finnerty, Natalia Reisel and Xun Zhong

Journal of Financial and Quantitative Analysis, 2025, vol. 60, issue 4, 1891-1924

Abstract: We examine a link between bond exchange-traded fund (ETF) creation and redemption processes and the underlying bond market liquidity. Using daily creation and redemption data, we find that including a bond in a creation or redemption basket has a favorable impact on the bond’s liquidity for both high-yield and investment-grade markets. The improvement in liquidity persists during times of market stress with this impact being stronger for redemptions than creations. Our results suggest that ETF mispricing arbitrage explains the improvement in bond liquidity. However, we also find evidence that transaction costs and bond inventory management limit the ETF arbitrage.

Date: 2025
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