Matthew Tucker is head of investment strategy for fixed income at Barclays Global Investors in San Francisco. IndexUniverse.com caught up with the busy bond executive on Thursday to find out how the ongoing credit crunch is impacting iShares' exchange-traded funds focusing on fixed-income markets.

IndexUniverse (IU): How is today's volatility impacting spreads between short- and long-term Treasuries?

Matthew Tucker (Tucker): As a result of the credit crunch and the significant flight to quality in Treasuries, we've seen a steepening of the yield curve as investors have moved towards safer, short-term securities. The spread difference between 2- and 10-year Treasuries has gone from about 150 basis points at the beginning of September to around 200 basis points. This type of yield curve flattening is fairly common during economic disruptions.

In terms of bid/ask spreads, it's important to note a general decline in liquidity across the fixed-income market sectors. This has been driven by the removal of significant fixed-income counterparties as well as general credit concerns about other counterparties. In addition, as a result of the general crisis in credit markets, participants are less willing to commit capital at this time. We've seen a significant drop in volume as well as available liquidity across fixed-income markets.

Since fixed-income ETFs trade on exchanges, it should be noted that they're providing an additional source of liquidity for some investors who now have limited access to bond markets. ETFs are serving as price-discovery vehicles in these markets.

IU: Can you explain how that's working given increased market volatility?

Tucker: In the current bond market, we're seeing a reduction in the frequency with which individual securities are being traded. This means that some securities which are normally very liquid are experiencing a reduced number of observable trades in the market. As a result, market participants trying to access the value of those securities are finding a lack of data.

Intraday ETF prices are helping to fill that gap. These are actionable prices where all market participants can buy or sell a basket of bonds.  So even though there may not be individual securities trades available at the moment, you can see how a basket trades through an ETF. And these baskets are very specific. For example, look at the iShares iBoxx Investment Grade Corporate Bond Index (NYSEArca: LQD). It's comprised of 100 liquid corporate bonds. In the current market environment, we're seeing a reduced number of trades in the fund's underlying bonds. In general, that reduction in number of daily trades has averaged roughly 25-30% in the past few weeks. So when the ETF is trading, it's providing the market information.

IU: Is LQD experiencing higher bid/ask spreads as a result?

Tucker: The bid/ask spreads have actually been fairly stable. In June, LQD was trading with bid/ask spreads of around 8 basis points. Today, that's up to 11 basis points. So there has been some impact on spreads, but it's a reflection of how the underlying markets have been trading.

IU: What about less-liquid parts of the market, such as high-yield bonds?

Tucker: The story is very similar to investment-grade markets. We've seen a definite reduction in liquidity and transactions. In these markets, however, the price-discovery impact actually increases. In less-liquid markets, there is actually less information about where the underlying securities are trading for all market participants. So bid/ask spreads for an ETF such as the iShares iBoxx $ High Yield Corporate Bond Index Fund (AMEX: HYG) have widened. But they've been in line with the rest of the market.

In June, the average bid/ask spread for HYG was 18 basis points (.18%); today it's averaging around 35 basis points. Under normal conditions, the average bid/ask spread now for individual high-yield bonds is around 100 basis points. That has gone up to 200 basis points or more, depending on the specific issue you're trading. So even though we've seen a widening bid/ask spread for HYG, it's still less than the spread an investor would typically pay for trading high-yield bonds in a more-normal market.

IU: Are spreads an issue in Treasuries now?

Tucker: The 30-year Treasury bond typically trades around 3 basis points in terms of bid/ask spreads. It's now trading around 6 basis points. That's what institutional participants would typically be paying to buy those individual securities. 

By the same token, we can look at the iShares Lehman 20+ Year Treasury Bond Index Fund (NYSEArca: TLT). The ETF's bid/ask spread in June was trading at 1.2 basis points, or 0.012%. Today, it's trading at a spread of about 5 basis points. So even within the Treasury market, we've seen a widening in spreads. And that's being reflected in iShares fixed-income portfolios.

IU: How are international bond markets holding up?

Tucker: The emerging markets have also been severely impacted by the credit crunch and flight to quality. We have an emerging markets bond fund, the iShares JPMorgan USD Emerging Markets Bond Index Fund (NYSEArca: EMB). We've seen a widening of spreads in that fund. But it has been in line with the overall market. In June, EMB had a bid/offer spread of 20 basis points; now it's around 50 basis points.