Bond ETFs untested

David MoonBlog

Exchange Traded Funds (ETFs) holding bond portfolios have quickly become popular among individuals seeking both lower risk and fixed income, but until tested by higher interest rates, we can’t know if they will fulfill those promises. Wall Street has a long history of creating new products, touted as conservative investments, yet lacking a track record. And investors have a long history of being willing Wall Street guinea pigs.

In the 2000s, something called an auction rate security was sold as a higher-yielding alternative to money market funds, that is, until the market for these supposedly safe investments completely froze in 2008.

In the 1980s, Interest Only and Principal Only securities were created as a way for investors to individually tailor their income and risk. It was an illusion. In the second quarter of 2009, 29 public companies sold out of the market with losses ranging from 60% to 80%.

Portfolio Insurance was supposed to prevent losses during periods of volatile stock prices, but actually did the opposite in October 1987, exacerbating selling pressure and leading to a single-day, 23% stock market collapse.

Like the preceding examples, bond ETFs promise to be transformational investments. Are they?

Bond ETFs promise an investor the intra-day liquidity of a stock with the predictable income of a bond. Bonds are generally less liquid than most stocks, meaning that a company’s bonds may trade less frequently than its common stock or that the price to buy and sell a bond is higher than that of a similarly sized stock trade. ETFs claim to be able to provide higher liquidity than the moderately liquid assets in its portfolio. It sounds very similar to claims made about mortgage backed securities prior to the mortgage meltdown in 2008-09. Promotors claimed they could create a high-grade asset by combining a bunch of low-grade assets.

In the same way it’s difficult to make a great football team out of a group of bad football players, it is unlikely to create a dependably liquid investment with a collection of only moderately liquid assets.

Like their stock cousins, bond ETFs are typically based on an unmanaged index. Positions within any index are typically weighted by some size measure. While a stock index is usually weighted by the size of the companies within the index, a bond index is usually weighted most-heavily toward companies that issue the most debt, which in many cases, increases the risk of a company – and the bond index.

There are several reasons to question the promises of exchange traded bond funds. We won’t know if they can meet those promises until observing their performance in periods of market distress.