Bond Exchange-Traded Funds

inSight

12 May 2005

Bond Exchange-Traded Funds

Bond Exchange Traded Funds are shortly to be introduced in this region as part of the Asian Bond Fund 2 Initiative.

The EMEAP* Group of central banks and monetary authorities, of which the HKMA is a member, has announced today that the Asian Bond Fund 2 (ABF2) Initiative has moved into its implementation phase. Among the various features of the ABF2 Initiative, the bond Exchange-Traded Fund (ETF) is worth highlighting as a fixed-income investment tool that is new to this region.

While bond ETFs have been available for quite sometime in the US and Europe, there has so far been no such low cost vehicle in this part of the world. The ABF2 Initiative, which has the overall aim of broadening and deepening the bond markets in the region, will be introducing this new asset class to Asia. As part of the Initiative, subject to approval by the relevant authorities, the Hong Kong Fund and the Singapore Fund will be launched as a bond ETF and will be offered to the public in the next few months, while several other EMEAP economies, such as Malaysia and Thailand, are seeking to work on new regulations to pave the way for the launch of bond ETFs in their respective markets.

A bond ETF is by design a passively managed fund that seeks to achieve a performance corresponding to the price and yield of its underlying benchmark index, which normally comprises a basket of bonds issued by a range of issuers and of different maturities along the yield curve. In terms of operation, a bond ETF, similar to an equity ETF such as the Hong Kong Tracker Fund, provides an in-kind creation and redemption mechanism. Under this mechanism, units of the fund can be created by surrendering the basket of benchmark bonds to the fund: in the case of redemption, the fund manager will provide the basket of benchmark bonds in exchange for the units being redeemed.

The in-kind transaction mechanism works in the following way: when the trading price of the fund units is higher than the net asset value of the underlying bonds, investors will have an incentive to purchase the underlying bonds and exchange the bonds for units of the fund, and then sell the units on the stock exchange, and vice versa. This arbitrage mechanism helps ensure that the trading price of the fund units will be close to the net asset value of the units. Fund managers usually set a minimum trading size for in-kind transactions in order to minimise operating costs. Smaller investors will not be involved directly in in-kind transactions. However, small investors will still benefit from the mechanism, since it will help mitigate the risk of a prolonged deviation of the trading prices of fund units from the market value of the underlying bonds. More broadly, the in-kind mechanism also helps generate trading activities of the underlying bonds, thereby adding liquidity to the underlying bond market.

From the investor perspective, in many ways a bond ETF represents a low-cost, efficient and convenient investment choice for investing in the bond market. First, it provides exposure in a range of bonds of different maturities with one trade. In addition, since the underlying benchmark index will have a monthly rebalancing procedure to include new issuances and exclude bonds approaching maturity, the average yield of the fund will adjust towards the prevailing market yields over time. In contrast, an investor holding a portfolio of individual bonds would have to conduct this rebalancing process himself. Secondly, compared with unlisted bond funds, investors in a bond ETF will be able to invest or liquidate their investments in the fund by buying or selling units of the fund on the stock exchange, which generally involves lower transaction costs and trades in a manner that is familiar to investors at large. Thirdly, the price discovery process of a bond ETF will be more transparent than that for a traditional unlisted bond fund, as the information on price quotes and transacted prices are conveniently accessible to the public through the stock exchange.

As with any other fixed income product or investments in general, a bond ETF is subject to market risk. The trading price of a bond ETF may rise or fall according to the demand and supply of the units of the fund on the stock exchange, while the net asset value of the fund may fluctuate in tandem with price movements of the underlying bonds. Furthermore, the trading price of the units of the fund on the stock exchange may not conform to the net asset value of the fund at all times given the two are determined by separate mechanisms. Investors should consider these risks before they consider investing in a bond ETF.

 

Joseph Yam

12 May 2005

 

*EMEAP is a forum of central banks and monetary authorities in the East Asia and Pacific region established in 1991. EMEAP's primary objective is to strengthen co-operation among its members. The eleven members include the Reserve Bank of Australia, People's Bank of China, Hong Kong Monetary Authority, Bank Indonesia, Bank of Japan, Bank of Korea, Bank Negara Malaysia, Reserve Bank of New Zealand, Bangko Sentral ng Pilipinas, Monetary Authority of Singapore and Bank of Thailand.

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Last revision date : 12 May 2005