Paul Volcker once quipped “the only thing useful banks have invented in 20 years is the ATM.” Based on this quote I’d wager that Dr. Volcker has never traded retail bonds. Trading retail bonds can be frustrating both in terms of costs and timing. Had Dr. Volcker been active in trading retail bonds I’m sure that he’d agree that fixed income ETFs have been incredibly useful in allowing investors to efficiently gain access to bond markets.
As a fixed income portfolio manager, I’ve been dealing with bonds for most of my career. A few years back I built my own portfolio of bonds and although the trading costs were high I felt a particular issuer had been unfairly punished in the market and provided an opportunity. From the institutional side of things, I had access to a number of bond “runs” from Wall Street dealers. Runs are lists of inventory that banks hold usually with both bid and offer quotes. With this access I could see levels that were quoted by all the big sell side players. When trying to buy these bonds in my personal account I was amazed to see the quotes I got from my online brokerage were several percentage points off from where I could see institutional accounts trading. I vividly recall one distressed name that was trading around $60 by institutional investors but was quoted at $85 by my personal brokerage account. When I called my fixed income sales desk I argued with them saying that I could see where the bond was trading. I even offered to make the connection to the dealer I knew was offering the bond at a good level but I quickly found out that retail investors cannot expect to transact anywhere near institutional levels. Intuitively the poor liquidity made sense. Knowing that trading in larger or institutional sizes narrows bid / ask spreads and the ability to go to multiple dealers helped bring down the costs of trading. While most of fixed income still trades OTC (over- the- counter), the current landscape for trading bonds is quite competitive and some heavily traded names can be bought and sold for less than 25 bps (round trip). On the other hand, retail investors trying to access the bond market have little options and can suffer high trading costs as their options are limited and they are forced to rely solely on their brokerage platform for best execution.
I recently moved and was forced to liquidate much of my personal savings, including my bonds, to come up with funds to buy a house. I had planned to hold these bonds to maturity but circumstances had changed and I now had to sell my bond holdings to secure my mortgage. The experience of forced selling was rough. I basically was at the mercy of my online brokerage account’s fixed income sales desk. My bonds did not trade often and the sales desk needed over two days to liquidate the positions. Again, the prices that I received for the bonds in my portfolio were nowhere near where I saw the bonds trading on the screens but I had no options. In the end, I learned the hard way that accessing fixed income through retail bond investing had its limitations.
Hindsight is twenty-twenty and if I had the opportunity to do it over again, I would consider accessing the bond market through an ETF and I would encourage others to consider ETFs as a potential way to access the bond market and perhaps avoid making the same mistake I did. ETFs offer investors a diversified basket of securities that minimize idiosyncratic or issuer specific risks for a relatively modest fee. ETFs trade throughout the day and have potential tax efficiencies over mutual funds. Additionally, the inkind create and redeem mechanism of an ETF can help decrease the amount of trading a fund must bear and therefore may help bring down trading costs to the end investor. Fixed income ETFs have become liquidity vehicles for many investors as investors are able to leverage the deep liquidity of the market to access exposure for relatively low cost. For example, High Yield fixed income ETFs now trade $1.5bn on average per day but a much smaller percentage of that activity translates into primary market activity. 1 Furthermore, Fixed income ETFs have given retail investors a way to access previously difficult sectors of the bond market, including High Yield, Emerging Markets and International Bonds to name a few. Retail investors looking to gain exposure to these sectors previously would have to pay specialty bond managers high fees but now trading is simple, efficient and cheap. For these reasons and more I have to respectfully disagree with Dr. Volcker’s comment about the lack of financial innovation. I believe that fixed income ETFs have been an incredibly important innovation allowing access efficiently to markets for individual investors around the world.