Collateral dominates structure.
Page from Alchemy treatise, c. 1300. Source: Wikipedia
That’s an investor’s way of saying that you can’t turn lead into gold. It’s been an investment theme of mine for as long as I’ve been managing money.
I started my investment career trading bonds in the mid-‘80s. Mortgage-Backed Securities were a new thing. Investors were starting to learn about prepayment risk, as interest rates fell and borrowers refinanced their double-digit mortgages. All those full-faith-and-credit Ginnie Maes were paying off early, and investors who paid premiums for fat coupons found that prepays could sometimes give them negative yields – way before quantitative easing was ever considered.
To manage this prepayment risk, some Wall Street types created Collateralized Mortgage Obligations: CMOs. By bundling a bunch of Mortgage-Backed bonds and sequencing the prepayments, investors could get mortgage bonds that behaved more like traditional bonds. First they only paid interest, then the principal was quickly paid down. By structuring the principal payments, CMOs were supposed to reduce or eliminate prepayment risk.
CMO Tranches. Source: Glynholton.com
But they didn’t. Collateral dominates structure. When 30-year mortgage rates hit new lows in 1993, CMOs paid off as quickly as any other mortgage. You can’t turn prepayment lead into bullet-bond gold.
Fast-forward to today. Mutual funds offer daily liquidity in all kinds of assets: emerging market stocks, foreign government bonds, currencies, non-investment grade bonds. But daily liquidity wasn’t all that easy – investors still needed to wait for the market’s close. Exchange Traded Funds offered exchange-based liquidity – trading every minute, or even more frequently. ETFs make it seem that investments that were difficult to trade could be bought or sold at a moment’s notice.
But while the funds are liquid, the underlying instruments may not be. Illiquidity is still illiquidity. Whether it’s high-yield bonds or micro-cap stocks or private real-estate trusts, a collective instrument ultimately transmits the risk-characteristics of its underlying constituents, even if it has a blue-chip financial architecture designed by a top Wall Street legal firm and approved by the SEC. Collateral dominates structure – kind of like the logical law of identity: A equals A.
That’s why junk-bond ETFs usually trade at a modest premium or discount to their net asset value – and sometimes they’re way off. The underlying bonds are hard to buy and sell. When a lot of money flows into or out of the fund, the price has to reflect the expected transaction costs. It’s not that the index value is bogus, it’s just its decimal-point precision doesn’t allow for the nuances of a market-maker’s spread. And when big news or fund-flows hit an illiquid market, the bid/ask spread gets wider.
Junk Bond ETF discount/premium to Net Asset Value. Source: Bloomberg
Structure can’t take risk out of a market. Over the years, Wall Street has tried to repackage risk into different types of vehicles. But prepayment risk and interest rate risk and credit risk and illiquidity risk weren’t eliminated, they’re just out of sight and out of mind. The right circumstances will bring them back out into the open, though. If investors think that the risks have been reduced, this is hazardous to their financial health.
The danger doesn’t come from the risks we know. It’s the risks we take that we’re not aware of that get us into real trouble.
Douglas R. Tengdin, CFA