US Videos

Bringing Institutional Bond Pricing to Individuals

Ben Johnson, CFA

Ben Johnson: Hi. I am Ben Johnson, director of exchange-traded fund research for Europe for Morningstar. I am here at the 2011 ETF Invest Conference, and today I am joined by Darrin DeCosta of Accretive Asset Management. Thanks for joining me, Darrin.

Darrin DeCosta: No problem, my pleasure.

Johnson: So Accretive provides sort of the intellectual capital, the indexes that are underlying Guggenheim's BulletShares products. Can you speak to us a little bit about the opportunity you saw to create targeted maturity fixed-income indexes?

DeCosta: Absolutely. It really started with an observation that we made back in late 2008. We surveyed a number of advisors, and what they all came back and said was, "Hey, when it comes to fixed-income investing, I tend to use individual bonds rather than bond funds." It was kind of a revelation to us because when you think of the equity markets in that analog, the vast majority of investors use packaged products, but on the fixed income side they prefer to use individual securities. So we started asking questions about what it was they found so useful about individual bonds held-to-maturity, and they said they enjoyed the permanence in definition that an individual bond would provide for their client, the sense of knowing what you own, being able to construct custom portfolios that respond directly to the advisor's needs.

Johnson: Now there have been a number of criticisms, a number of issues that have been raised with indexing bonds and in particular in the pricing of bonds, because bonds are a far less liquid than shares. What are some of the unique considerations that you take into account as you construct these indexes to make them very investable?

DeCosta: Well, the first thing to look at whenever you're talking about fixed income is can this index actually be replicated in a meaningful way, but still remain representative of the entire marketplace and diversified? Obviously diversification is one of the key benefits here you get out of any ETF or index-based strategy. So we really started out with a goal of providing something that was both liquid and diversified. We did that by looking and constructing rules for the indexes that would include a large number of bonds that would give the investors that diversification they were looking for and still have the ability to trade in and out of those portfolios at reasonable bid-ask spreads. So, it really started by looking at the characteristics of the bonds that would go into the portfolio and then designing the portfolio as a result of that.

Johnson: Now, what are those key characteristics that you look for, and are there some segments of the bond markets that lend themselves more easily to being indexed than others?

DeCosta: You know it's a really interesting question. There are a number of research papers that have been done looking at liquidity really since the advent of the trace database going back to 2002. The vast majority of the bonds that really stay liquid and continue to trade through time tend to have a couple of common characteristics. One is they tend to be large benchmark issues and a benchmark issue is something, an issue that has at least $500 million par issued and outstanding.

The other types of characteristics is that they tend not to have crazy bells and whistles, things that investors can understand and easily price. So when you look at the types of bonds that are going into our indices, it's really these bonds that investors would otherwise buy if they were constructing a portfolio themselves but focused more on the larger size of the investable universe.

Johnson: One of the recurring themes as it pertains to ETFs is that in many ways they've democratized institutional level pricing and access and execution making that level of access really available to the full spectrum of investors from actual institutions to retail investors. So as it pertains to target maturity fixed-income exposure, how does having that available via an index, and in turn an ETF wrapper, play out in the markets with your indexes?

DeCosta: An insight that we made actually just this summer and some research that we'll have coming up to our website pretty shortly, we looked at what is happening to the average retail investors or the average financially advised retail investors out there and compared their level of execution when they buy individual bonds to what institutional investors trading in those exact same bonds are actually receiving. Based on our research, we see an approximate markup of 65 basis points round-trip.

What does that mean? If an institutional investor is buying a GE bond with a 5% yield to maturity of a particular CUSIP with a particular maturity date, retail investors on average are paying a markup that effectively lowers their overall yield to roughly 435 basis points rather than the 5% that you'd see that the institutional investor would get. And we see that as being a very, very meaningful difference, especially in a low-interest-rate environment.

One of the best characteristics of any ETF is that it can help to enhance the underlying liquidity of the instruments in which it's actually investing. One of the benefits here of the BulletShares-based products is it provides a market proxy that any retail investor can take a look at it and say, "Is the individual bond that I'm about to buy a reasonable-yielding bond relative to what my other opportunity set is?" The problem in the industry for retail investors, at least, is that they don't have enough information to really be able to understand what it is that they're getting and if it's a fair yield or not.

Johnson: So in having these exchange-listed instruments tracking specific maturities and index, all maturing at a specific date or a specific year for that matter, we're bringing really visibility to what had been in most instances a very opaque market for a broad swath of investors?

DeCosta: That's exactly it. The average retail investors have one venue with which to trade. The average retail investors have no sense for what a fair market value is for a particular security. They don't know whether or not that yield is, in fact, the correct yield, and they really don't a sense for what others trading that exact same security would actually have gotten at the point they wish to trade.

The beautiful thing about any exchange-listed product is the ability to see on the screen what the bid and the ask are, and you can make the decision at that point. Does that make sense given the information I have available? Does it make sense to acquire that security in hopes of delivering a particular outcome? That's one of the real advantages here, generally speaking of ETFs but also BulletShares-based products.

Johnson: So the great democratization continues.

DeCosta: Absolutely.

Johnson: Well, thanks for joining me today, Darrin.

DeCosta: Thank you.