The problem with bond ETFs

October 6, 2009
Eleanor Laise finds that the market in bond ETFs is rather messy, to say the least:

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The WSJ’s Eleanor Laise finds that the market in bond ETFs is rather messy, to say the least:

State Street Corp.’s SPDR Barclays Capital High Yield Bond ETF fell nearly 1% in the 12 months ending Aug. 31, even while its benchmark gained 6%. Part of the problem: The index contained some lower-quality bonds that the ETF couldn’t get, and when those bonds rallied, the fund got left behind, says Jim Ross, senior managing director at State Street.

The benchmark in question, it’s worth noting, is the Barclays Capital High Yield Very Liquid Index. That’s evidently “Very Liquid” as in “can’t find these bonds to buy no matter how hard we try”.

The lesson of this story is that ETFs don’t work when they’re investing in instruments which aren’t exchange-traded:

Keeping ETF returns in line with the indexes has proven to be tough in the murky bond market. For most bonds, there is no centralized exchange matching bond buyers and sellers, and different market players can assign very different prices to the same bonds. Many bonds don’t trade for days at a time, and when they do, they can be costly to buy and sell.

It’ll be interesting to see whether anybody tries to launch an ETF based on a liquid, exchange-traded CDS index. That might solve most of these problems, but I know a lot of people who would be dead-set against such a product, since its very existence would imply the dreaded “naked shorting” of CDS by dastardly speculators. Is a failed investment product better than a liquid derivatives market?

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