(Bloomberg Opinion) — It was bound to happen. Following the launch a few weeks ago of some exchange-traded funds focusing on a single stock, one issuer has come up with single-bond ETFs. These three new funds will hold either the benchmark three-month US Treasury bill, two-year US Treasury note or 10-year US Treasury note. I described single-stock ETFS as financial mutants that benefit nobody, but single-bond ETFs are a surprisingly good idea. In fact, I’m a bit shocked that nobody thought of it until now.
The primary benefit of these funds as I see it is that they give both retail and institutional investors a way to easily trade in Treasury securities, which is revolutionary. Bonds are complicated, which is why a lot of people – including hedge funds – don’t trade them. It’s a lot easier to buy shares of something that trades on an exchange and not deal with the institutional-sized lots, coupon payments and messy cash flows associated with fixed-income assets. Taking a single bond and putting it into an ETF wrapper solves these problems for investors. It’s not hyperbole to say the implications are huge, and that these funds have the potential to disrupt the ETF industry as well as futures exchanges.
Even for the biggest institutions, let alone retail investors, there is no easy way to buy a specific Treasury note or bond. To do so would entail opening an account on the government’s TreasuryDirect platform and buying odd lots of bonds directly from the Treasury Department at auction, which you would then have to hold to maturity. You could also gain exposure by purchasing bond futures, but then you are dealing with margin issues, basis risk (the spread between cash bonds and futures) and figuring out the cheapest-to-deliver bond. Another option is to buy an open-end, intermediate-term Treasury mutual fund, but unlike with an ETF you would only have “liquidity” at the end of each day when mutual fund prices are updated.
In recent years, the most popular way to gain exposure to the Treasury market was through the iShares 20+ Year Treasury Bond ETF. But the ETF holds a portfolio of bonds across a range of maturities, from 20 to 30 years. As such, the characteristics of the ETF change over time, which sort of diminishes the safety and predictability aspect of owning government bonds. In other words, for all the interest in the iShares ETF, with millions of shares and hundreds of thousands of related options contracts traded, it is a portfolio with risk that is not constant. The new 10-year ETF is designed to track the performance of the ICE BofA Current 10-Year US Treasury Index, which simply rolls the on-the-run bond from one issue to the next.
Even so, it’s unlikely these funds will be used as a long-term investment vehicle, but rather as a trading vehicle. But as the iShares 20+ ETF has proven, having grown to $25 billion in assets, being a trading vehicle can be lucrative for the issuer. The new 10-year Treasury ETF charges a fee of just 15 basis points, which is on the low side for a “trading” ETF, but matches the fee charged by the iShares ETF. And I’m sure that options tied to the new ETF will be listed, which should help it steal market share from the iShares ETF and others like it. That will encourage other ETF issuers to come up with similar products.
I would characterize this as a positive financial innovation; in the world of ETFs, there are much worse. The iShares bond products have built up a great deal of credibility over time, and one of their attractions is that you can trade long-dated options on them, which you can’t do with bond futures. These new single-bond ETFs will be one of the more successful product launches of the year.
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Jared Dillian at [email protected]
