The writer is director of ETFs at Richard Bernstein Advisors

Providing more liquid means to facilitate transactions is the primary function of financial markets. Before stock markets, the only way to participate in company ownership was to actually own a piece of the business. Before the futures market, one would have had to sell pork bellies and cotton in a physical marketplace. Markets trade instruments that are more liquid than their underlying assets.

Fixed-income exchange traded funds may be a route to much-needed bond market liquidity, just as commodity futures provided liquidity to physical markets and stocks facilitated easy transfer of corporate ownership.

Despite well-developed and liquid markets for many asset classes, bond markets remain notoriously illiquid. Capital requirements at large banks have become more stringent since the global financial crisis. Dealer balance sheets hold a fraction of the inventory of corporate bonds that they previously did.

Adding to the liquidity woes, central banks around the world have bought astounding quantities of government and mortgage debt, effectively cornering the market and removing a huge amount of the “float” in what should be the most liquid securities in the world. The Federal Reserve at one time owned more than 50 per cent of the 10- to 20-year Treasury bond market. With such market share held by a single entity, it should be no wonder that bond liquidity has dried up and volatility has risen.

Fixed-income ETFs could provide a solution, as multiple paths to liquidity allow investors greater flexibility. First, ETFs trade on an exchange and do not need a dealer to provide a bid or offer. This alone creates advantages as there is real-time price discovery for fixed-income ETFs that does not exist for individual bonds.

Investors may not fully appreciate the fixed-income ETF market has replaced the underlying bond market for setting price discovery for many fixed-income assets. Price discovery is always set by the pricing of the most liquid market, yet some argue an ETF is not functioning properly when it trades at a discount to the underlying assets.

However, the underlying bonds are not trading and therefore cannot be priced accurately. If the underlying instruments were to trade, they would be likely to transact at prices significantly different from their last actual trade, whenever that was. This is like the fallacy of private equity and debt investments being less volatile than similar public investments.

You cannot get accurate price discovery when an asset does not trade or is not marked to market. Second, ETFs can be created and redeemed through the most liquid baskets of securities that do not incur a forced sale in the open market. Ironically, the liquidity in these bonds has resulted in the rest of the bond market becoming less liquid.

Improved liquidity has not arisen without its doubters. Some have suggested more liquid fixed-income ETFs that incorporate illiquid underlying securities (bonds) risk financial disaster. However, countries, municipalities, corporations, even our own mortgages rely on the fixed-income market and its investors to ensure our economies do not fall into financial ruin. Yet this cornerstone of finance barely trades, making price discovery difficult, inefficient and costly to all. ETFs seem part of the solution rather than the problem.

Bond investors may be woefully unprepared for managing a changing macro landscape where higher inflation could necessitate more tactical decisions on asset allocation than what was needed during the past 40 years. The bond market’s inherent illiquidity will hamper active management and the role of fixed-income ETFs is likely to expand.

Already during periods of volatility, capital floods to fixed-income ETFs, driving greater price transparency and liquidity. For example, during broader market turmoil in March 2020, the largest corporate bond ETF — the iShares iBoxx $ Investment Grade Corporate Bond ETF known by its ticker LQD — traded daily, in significantly more volume than before or since. At the time, individual bond transactions barely existed because of significantly wider trading spreads. Bond ETFs weathered the storm, serving as the only way to reasonably trade risk.

Going forward, investors will need to be cognisant of how their bond portfolios need to change. Given the macro liquidity, economic and profit landscape, bond ETFs, not individual bonds, give the best chance for survival and opportunity.

Michael Contopoulos, director of fixed income at Richard Bernstein Advisors, contributed to this article. RBA is an investor in fixed-income ETFs but does not at present hold LQD in any of its portfolios