Who in their right mind would invest in a corporate bond ETF?

By Allan Lane, Algo-Chain – At a point in history when many market commentators have gone completely gaga about the story relating to negative bond yields, it may well surprise many readers that 2019 has been a stellar year for investing in Fixed Income ETFs.  

Indeed, as of 8 Oct 2019, the top 50 ETFs listed on the London Stock Exchange have returned anything from 13 per cent to 28 per cent year-to-date.

What is it about fixed income investing that somehow turns rational, grown adults into befuddled individuals? I'd first caught wind of this phenomenon in the late 1990s when speaking to a number of headhunters it became quite clear that fixed income specialists were in short supply and could name their price.  Given that bond ETFs were nowhere to be seen at that point in history, I can only assume the over-reaction was the by-product of an excessive use of jargon.

To be fair there are quite a few facts about Fixed Income ETFs that might surprise the innocent newcomer.  The main one being that they don't really behave like bonds.  There you go, I have said it: bond ETFs don't have a lot in common with cash bonds, and with that observation out of the window goes any previously held notion of what it means to know the basics.

In the brave new world of Fixed Income ETFs, all that you learnt in graduate school about bonds needs to go into the bin.  

  • Single name bonds when redeemed at maturity pay the bond holder 100, but this is not true with ETFs.  
  • Individual bonds mostly are issued with a pre-determined maturity date, again not true of ETFs that in principle could go on forever.
  • Bond ETFs trade via an exchange, unlike their primitive cousin, the underlying bonds themselves which trade OTC.  
  • When volatility occurs in the market, the liquidity of bond ETFs often goes up unlike single bonds that show more of a drying up tendency.

Like many others of my ilk, I had been out of grad school for two years when in 1989 Michael 'Moneyball' Lewis published his seminal book Liar’s Poker that changed my life for ever. The army of Wall Street quants as we became known, couldn't believe our luck as Lewis's high octane tale of life in the bond trading fast lane sold the dream that there were big bucks to be made if you could code and were a dab hand at stochastic calculus.

Welcome to the world of the quant, when in the early 1990s there was no limit to the intellectual firepower banks were prepared to throw at the burgeoning Derivatives Markets.  All manner of structured products would soon roll off the equity derivatives assembly lines, Lookback Options, One Touch Options, Barrier Options, need I go on?  Imagine my chagrin as I landed my first job at the French Bank Paribas, complete with its marbled hallways at its London headquarters located on Wigmore Street, only to find my first project was to learn how to price a bond.  

Unless you have had to personally write the code to cover all manner of product variations, it's unlikely you will appreciate what a tedious task it is.  Let's not forget bond investing is all about getting paid your hard-earned interest and woe betide any analyst who doesn't accurately count the number of days interest due.  Should the bond holder earn daily interest over the weekend, what about on Bank Holidays? Take it or leave it, somebody needed to develop the tools that the bond trading desk would rely on.

Eventually, over time, I would branch out from the proverbial sell-side to the buy-side, before making the final leap into a world where the financial adviser was king.  If I wanted to make it as a Discretionary Fund Manager, I would first need to learn how to think like a financial adviser, but if I was to do this I needed to update the language I used.  Whether this explains why so many people’s views on Fixed Income ETFs held has become so emotive, I can’t be sure. I was once asked “Who in their right mind would invest in a corporate bond ETF?” and from that point on I spent much time explaining the features and benefits of these type of products.

As more and more voices promote a vision of ETF complexity, compared to the go-getting years of the Derivatives’ product bubble that ran unfettered from 1990 to the Global Financial Crisis of 2008, nothing could be further from the truth.  It’s truly amazing how straight forward many of today’s fixed income investment products are.  What’s hard to fathom though, are those undercurrents that drive opinion and sentiment.  For that reason alone, I’m confident that very few of us know how the fixed income negative rates story will play out, and what a dramatic story it might turn out to be.

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