Smaller investment-grade corporate bond issues, under $500 million, trade materially less frequently than larger issue bonds among a sample study of the underlying holdings of five major U.S. corporate bond ETFs, says Fitch Ratings.

Low trade frequency has the potential to become a more significant issue under market stress, which Fitch believes is a growing risk as bond inventories are reduced and possible interest rate hikes lie ahead.

While measuring bonds' attributes that contribute to liquidity quality is challenging, issue size is a significant influence. Fitch's analysis simply corroborates the point within the scope of major bond ETFs. The matter has specific importance for ETFs because they trade continuously, while the underlying bonds supporting the ETFs' prices do not. A wide mismatch can lead to ETFs trading at larger discounts or premiums to their underlying assets.

Fitch's sample sizes were grouped by three cohorts from each of the five ETFs. The cohorts were based on rank in holding size within the ETFs. The first cohort represented the top 25 holdings of each ETF, the second cohort accounted for 25 more bonds from the 75th percentile range of each ETF's holdings; finally, another 25 bonds from the 50th percentile range were chosen. After exclusion factors, the total sample set was 358 corporate issues. Fitch plotted issue size versus the average number of days the issue traded in the market over a four-month period ending Nov. 28, 2014.

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The data show that for each grouping of progressively larger issue sizes, trade frequency increased, on average. For example, issues sizes of over $3 billion traded 98% of the days over the examination period, whereas issue sizes of $250 million to $499 million only traded on 28% of the days over the same period. The incremental impact of size on trade frequency dropped most significantly when moving to the $250 million to $499 million range (the smallest bucket) from the $500 million to $999 million range. Separately, Fitch found a strong relationship between a bond's ranking order in the ETFs' holdings and trade frequency. This implies that corporate bond liquidity is highly stratified, with the bulk of trading activity concentrated in a small number of issues relative to the overall market.

In previous research on high yield bond ETFs, Fitch found that these ETFs were increasingly being used as favored vehicles to express changing views on the high-yield market. To some degree, this reflects the increasingly limited liquidity in underlying high yield bond markets, as well as the growing importance of liquid investments at a time when views on the future path of interest rates and macro fundamentals are shifting continuously.

For prior comments on bond market liquidity and high yield ETFs, please see "Corporate Bond Liquidity: A Look Below the Surface," Dec. 22, 2014; "High Yield Bond ETFs: Investors Seek Liquidity During Market Volatility," Oct. 20, 2014 on www.fitchratings.com.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

Applicable Criteria and Related Research:

Corporate Bond Liquidity: A Look Below the Surface

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=833328

High Yield Bond ETFs: Investors Seek Liquidity During Market Volatility

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=795528

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Fitch RatingsRobert Grossman, +1 212-908-0535Managing DirectorMacroeconomic Research33 Whitehall StreetNew York, NYorMatthew Noll, CFA, +1 212-908-0652Senior DirectorFinancial Institutions - Fitch WireorMedia Relations, New YorkAlyssa Castelli, +1 212-908-0540alyssa.castelli@fitchratings.comElizabeth Fogerty, +1 212-908-0526elizabeth.fogerty@fitchratings.com